Lack of Seed Capital Impedes Incubations

Hedge-fund incubation firms, which act as middlemen between deep-pocketed investors and startup fund managers, are struggling with a growing mismatch between supply and demand.

On the one hand, the incubation shops are seeing heavy demand for seed capital from early-stage managers who have had little luck raising funds since the onset of the financial crisis. But on the other hand, institutional investors that were once eager to back incubation efforts have slashed their allocations for seed financing.

Incubation operators such as SkyBridge Capital, Protege Partners and Weston Capital are seeding fewer funds and providing less capital per manager. Incubation firms traditionally have been a key source of capital for startup managers, while also providing much-needed marketing and operational support.

"There's a lot of tire kicking going on right now," said one early-stage hedge fund manager who has been hunting for seed capital.

One incubation executive described the current market conditions as an "almost perfect storm." Most incubation firms, he said, are struggling to hold on to existing commitments from investors that are suddenly having second thoughts. The few investors still in the market are increasingly wary of multi-year lockups on their capital - a standard condition for incubation investments. Traditionally, incubators have counted on pension funds, endowments, family offices and wealthy individuals as their main sources of capital.

SkyBridge, a New York incubation firm, has reduced its standard seed deal to $25 million, from $50 million last year. Unlike some other incubation firms, however, SkyBridge continues to seed start-up vehicles. And with more managers competing for less seed capital, SkyBridge has been able to extract more favorable terms, said chief executive Anthony Scaramucci. So far this year, the $1.6 billion firm has provided seed money to Stonebrook Capital Management, Thomas Grossman's Union Avenue Advisors and a real estate-focused fund run by Mike Chacos and Judith Sciamma in London. SkyBridge expects to seed at least one more fund operator in the near future.

Early-stage managers without experience running their own funds are having the toughest time landing seed deals. But Jeffrey Tarrant, chief executive and co-founder of Protege Partners of New York, expects top talent will continue to attract seed capital on reasonable terms. His firm has seeded 20 manages since its inception in 2002. For now, however, "no money's moving at all," Tarrant said.

Albert Hallac, founder of Weston Capital, said his firm continues to make seed investments, albeit at a slower pace. It is currently raising money for a futures trader whose strategy is to exit all of his trades daily. At the same time, Weston is looking for a strategic partner or large investor to expand the incubation business.

"During the fourth quarter, things were very slow," Hallac said. "In the last couple of months, we're seeing four to five managers a week."

Robert Picard, former chief investment officer of multi-manager firm Optima Fund Management and now a senior advisor with Navigant Consulting, said the current pressures on incubation firms could lead to consolidation in the sector.

Scaramucci, the SkyBridge chief, said the financial crisis has led to a "restaging-of-talent cycle" similar to what occurred in the mid-1990s, when hedge fund superstars such as Daniel Och and Noam Gottesman got their start. Talented portfolio managers are now emerging from collapsed hedge funds and downsized proprietary-trading desks. The problem, Scaramucci said, is that potential investors are much more tentative about backing startups. As a result, it's taking incubation firms such as SkyBridge a lot longer to land new commitments.

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