Hedge Fund Seeding Via Fees-for-Seed Swaps Under Idiosyncratic Risk

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 problems 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. We also find that the ESFs manager's risk aversion can over-turn the risk-shifting incentives when the fund is likely to default while a cash-out option gives the ESF manager a higher incentive to hit the targets when the assets under management (AUM) are nearing the prescribed cash-out boundary. We find that it is more likely for a more risk-averse ESF manager to engage in risk-shifting when the cash-out option is about to be exercised while less likely if the fund has higher probability to be liquidated