Hedge fund seeding via fees-for-seed swaps under idiosyncratic risk

Abstract

We develop a dynamic valuation model of the hedge fund seeding business by solving the consumption and portfolio-choice problem for a risk-averse manager who launches a hedge fund through a seeding vehicle. This vehicle, i.e. fees-for-seed swap, specifies that a strategic partner (seeder) provides a critical amount of capital in exchange for participation in the funds revenue. Our results indicate that the new swap not only solves the serious problem of widespread financing constraints for new and early-stage funds (ESFs) managers, but can be highly beneficial to both the manager and the seeder if structured properly.

Hedge fund seeding with fees-for-guarantee swaps

“…A new financial contract, we refer to fees-for-guarantee swap, has been introduced in our paper with the aim of solving this problem. Another dramatic difference between Ewald and Zhang (2016) and our paper is the risk profiles regarding to seeders' investment. Thanks to the fees-for-guarantee swap, the seeder's investment downside risks in our paper has been well under control when the fund defaults, whereas in Ewald and Zhang (2016) the seeder could lost every penny invested in the fund.…”

“…3 Based on the Consumption-CAPM framework, Ewald and Zhang (2016) provides strong evidences for the benefits of fees-for-seed swaps.…”

“…4 For example, Larch Lane Advisors (LLC) has constructed a simple model to project returns and cash flows for a seeded fund, featuring the innovative seeding strategy. Ewald and Zhang (2016) provide first theoretical research for these problems under the seeding stage, but they only consider the fees-for-seed swap without insurance.…”

“…An companion paper by Ewald and Zhang (2016) has done a similar research on the hedge fund seeding businesses. With a strong focus on the effect of frictions of incomplete markets, such as idiosyncratic risks, Ewald and Zhang (2016) provides a dynamic valuation model of the hedge fund seeding business, by solving the consumption and portfolio-choice problem for a risk-averse manager, who launches a hedge fund via a seeding vehicle. Unlike Ewald and Zhang (2016) which spotlights the idiosyncratic risks of seeding business, we focus on the borne information asymmetry between seeders and ESFs managers.…”

“…With a strong focus on the effect of frictions of incomplete markets, such as idiosyncratic risks, Ewald and Zhang (2016) provides a dynamic valuation model of the hedge fund seeding business, by solving the consumption and portfolio-choice problem for a risk-averse manager, who launches a hedge fund via a seeding vehicle. Unlike Ewald and Zhang (2016) which spotlights the idiosyncratic risks of seeding business, we focus on the borne information asymmetry between seeders and ESFs managers. A new financial contract, we refer to fees-for-guarantee swap, has been introduced in our paper with the aim of solving this problem.…”