It’s getting both more expensive and less profitable to run a hedge fund — and new managers are seeking out more start-up capital to counteract their rising bills.
Hedge funds launched in 2018 required significantly higher minimum commitments from their investors compared with funds launched in prior years, according to a study of new hedge funds by Seward & Kissel. The hedge fund law firm also found a sharp increase in seed deals, which provide a large injection of locked-up capital to new hedge funds.
“All of this points to a need by the managers to reach critical mass earlier on,” said Steve Nadel, a partner at Seward & Kissel.
Among 3(c)(7) funds — hedge funds whose investor base is largely limited to institutions and wealthy individuals — Seward & Kissel found that the average minimum investment had risen to $2.5 million, up from $1.6 million in 2017. The rise in minimum investment levels was recorded across equity and non-equity strategies, but was most dramatic among hedge funds investing outside of equities.
According to the study, non-equity hedge funds required an average minimum commitment of$3.8 million — nearly double the $2 million start-up investment mandated by non-equity funds launched in 2017. For equity hedge funds, the average minimum investment was $1.8 million, up from $1.3 million in 2017.
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Nadel, who was the lead author of the Seward & Kissel report, said the rising investment minimums were partly to help new hedge funds get on the radar of institutional investors. “Some of the big institutional allocators, they may not even talk to you unless you have $100 million or more under management,” he said.
The other big reason for higher commitment minimums, according to Nadel, is simply rising operation costs in the hedge fund industry, particularly for the more capital-intensive non-equity strategies. “There are many more expenses in the industry today that didn’t exist ten years ago, like cyber insurance,” he said.
The trend toward quantitative investing and the increasing use of advanced tools like machine learning has also come with expensive computer software and hardware, not to mention the cost of computer science PhDs hired to build investment algorithms, Nadel added.
While costs have gone up, the fees paid to hedge funds by their investors have come down. The average management fee charged by a hedge fund launched in 2018 was 1.49 percent, while performance fees averaged 18.72 percent, according to Seward & Kissel.
Still, Nadel believes that management fees are hitting a bottom. “At some point you need to break even to cover all these increasing management costs,” he said.
Instead, Nadel sees investors shifting their attention to performance fees, focusing on modifications like hurdle rates — return targets that must be hit before managers can earn performance fees. According to Seward & Kissel, 20 percent of hedge funds launched in 2018 had a hurdle rate, up from 15 percent in 2017.