As hedge fund assets hit the US$1.81 trillion mark for the first time since the financial crisis, according to the May 2011 Eurekahedge Report, managers are increasingly tapping a new source of capital known as first-loss capital as funds compete to raise money.
What is first-loss capital?
Hedge funds have historically charged a 2 & 20 fee structure that being an annual 2% management fee based on the value of the assets and a 20% performance fee based on profits. Under the first-loss capital system the manager may provide 10% of the fund’s capital which, as the name suggests, takes the first loss in the event that the fund losses money. The upside for managers is that funds typically pay greater performance based fees that may be more than double the 20% industry norm; furthermore this fee may be paid monthly.
Although first-loss capital has been around since 2002 having been pioneered by firms like Topwater Investment Management LLC, the appetite for first-loss capital is stronger than ever as start-up funds compete for capital. This increase in appetite from investors may be partly due to investor reluctance to invest in traditional start-up hedge funds following the financial crisis whilst managers who are willing to back their own investment strategy and are willing to put their own money on the line to support it deserve a closer look.
For new managers who are struggling to raise capital and cover their costs, but generating steady returns, first-loss capital can help increase assets under management and cash flow through increased monthly performance fees. The hitch is if they suffer heavy losses, it is their money which is lost first.