First-Loss Capital and First Loss Hedge Fund Products
Industry assets are more abundant than ever before, but its distribution amongst hedge fund managers isn’t exactly what one would call egalitarian. Emerging hedge fund managers are finding it difficult to raise capital as majority of the assets at play usually end up at the hands of managers who handle upwards of $5 billion in assets. This is in spite of the studies that suggest that smaller or emerging managers perform better than their counterparts.
Due to this disparity in capital distribution, emerging managers are seeking ways in which they too could have a piece of the capital pie, so to speak. There are capital sources available to these smaller, start-up managers, ranging from traditional hedge fund seeding arrangements to acceleration capital. One source that has been gaining popularity lately is what is referred to as the “risk based managed accounts” or “first-loss” capital or “FIRLO” for short.
In first-loss capital programs, the capital provider that oversees the program usually allocates directly to the manager via the master feeder and into a separate account. To receive the allocation, the manager must contribute a capital equal to a fixed percentage of the total managed account. This usually ranges from 10%-20%, depending on the capital provider.
In FIRLO programs, the manager receives a performance fee that is higher than the normal industry standard. In return for this, it is the manager’s capital that first absorbs any loss incurred. The manager then receives 100% of all future profits until the amount of capital initially lost is returned. Only after it has been repaid to the manager will the profits be shared with the fund.
Why would a manager agree to such an arrangement? This is because there are rather significant benefits to a FIRLO program, including: 1. An increase in capital base, wherein firms often allocate significant amounts of capital to the manager; 2. high performance payout, which means that firms pay higher than the industry’s normal performance payout to the manager; 3. cost effective turnkey, which means that the cost to the manager is minimized as these firms handle all the set up and administration related costs; 4. Monthly or quarterly payouts, wherein the manager receives his split of the P&L on a monthly or quarterly basis in contrast to having to wait until the year’s end or post an audit; and 5. traditional allocations which means that certain first-loss groups are affiliated with traditional allocation vehicles such as fund of funds and the like, and so such groups will use these managed account as forms of active due diligence. They may allocate in the traditional way to managers who consistently perform well.
There is good reason for the growing popularity of FIRLO. After all, such structures allow managers to increase their business, create/generate cash-flow, and receive performance fees that are higher than the industry standard, all while building a track record. The capital raising space within the finance industry is becoming tougher and tougher. Risk based managed accounts give managers the chance to grow their AUM without having to cede a piece of their business to a seeder or accelerator in order to do so.