Less than one score and seven years ago, it was relatively easy for hedge funds and other private fund vehicles to gain early stage capital. They went to their networks of high net worth individuals, let a little word of mouth work its magic, and then waited for early investments to roll in. Due diligence was minimal, who you knew was paramount and a rising tide (the Bull Market) lifted all ships. If it hadn’t been for the shoulder pads, it might have been the golden age of hedge funds.
Now, of course, raising early stage capital is a whole different ballgame. From seeders to bootstrapping to joint ventures to Founders’ Share classes, there are a host of options available to emerging managers who want assets, although frankly most work better in theory than they do in practice.
Lately, most of the buzz has surrounded Founders’ Share capital. And for managers that are unable to secure bulk early stage financing from a seeder, founders’ shares may hold some appeal.
Founders’ shares generally reduce management fees by up to 50 basis points, while incentive fees may be reduced by up to 5 percent. Founders’ shares are generally offered for a limited time for only early mover investors and are discontinued when a specific asset level or time threshold is passed. Founders’ Shares, and their reduced fees, remain in effect as long as the investor maintains an allocation to the fund.
Founders’ Shares have a lot of perceived benefits, including:
- Founders’ Shares sound cool. Seriously. Investors feel more like they’ve build something, and that can be appealing to some.
- They create urgency. Because Founders’ Shares are only offered until a certain AUM threshold is reached, or for a certain period of time, theoretically this “limited time offer” should encourage investors to pull the allocation trigger. Hey, it works for Ronco...
- They entice fee-wary investors without sacrificing the entire fee structure of the fund.
However, just because they sound good in theory doesn’t mean they are a panacea for every fund.
- Managers should consider the capacity of the fund. If the capacity is low, the amount allowed in founders’ share classes must be balanced to prevent a general loss of profitability for the fund.
- Institutional investors who insist on a “most favored nation” clause may be eligible to receive the reduced fee structure. As a result, it is important to discuss any legal ramifications of founders’ shares with counsel.
- Marketing materials must be created that clearly outline the opportunity for early investors. These materials (as well as any databases to which you’ve reported fees) must be updated when the initial “founding period” is over.
Perhaps most importantly, it’s important to remember that sacrificing fee revenue is most dangerous when assets under management are low. Once a firm or fund has attracted $1 billion in AUM, even a 1% management fee will generate $10 million in fee revenues in a flat year. For a $100 million fund, that fee revenue falls to $2 million in a 2% and 20% scenario, and $1 million in a 1% and 20% scenario (assuming flat performance).
And of course, those numbers are BEFORE expenses. Citibank estimates that a typical $100 million hedge fund must spend $2,440,000 each year to keep the fund running. Factoring that into the equation, it’s easy to see how quickly a fund can go from hero to zero, particularly if performance doesn’t pan out.
So I said all that to say this. Founders’ Shares can be a great thing if used judiciously, but please do the math to determine how much of a great thing you can stand to offer.