New York law firm Seward & Kissel in its most recent analysis of seed investments in hedge funds, private equity funds and other investment vehicles shows such transactions returning to pre-pandemic levels even in the face of challenging market conditions in 2022.
The funds receiving significant seed investment dollars in 2022 were traditional long/short equity strategies, particularly those with defined industry or thematic focuses. Digital asset strategies, multi-strategy managers and event-driven strategies also accounted for a notable portion of the data set, officials said.
The report, the ninth annual for Seward & Kissel, also tracked the uptick in seeding activity to traditional private equity funds and other illiquid or “closed-end” fund structures. Officials said they would not be surprised if private equity seeding ultimately equals or exceed that of the hedge fund category.
Interestingly, investments in “hybrid” strategies, including positions in illiquid private companies, experienced a slight decline, likely reflecting a pullback in the tech and life science industries — two sectors in which private, illiquid investments have been significant historically, the report found.
Of the deals where working capital support is provided — which is now a substantial majority of seed deals — a clear preference has emerged for the deferral-based approach as a way of increasing the amount of capital available to fund the manager’s operations. In 2022, 64% of deals included working capital support, up from 59% in 2021 and 41% five years ago.
The transaction details with respect to lock-ups remain unchanged, according to the findings, as two or three year redemption periods remain. This is as strategies in high demand were resistant to fee compression, and these would be more liquid products and strategies able to provide enhanced liquidity to investors. The study also showed that seed investors sought protections to manage risks of market downturns and volatility, often negotiating performance-related lock-up release triggers.
The most common of liquidity rights negotiated by seeders are keyed to the protection of the asset value of the seed investment (e.g., breaches of, or changes to, the investment guidelines; negative performance) and events adversely affecting the manager’s future as a business (key person; bad acts; regulatory matters). Key person events remain the most common of these liquidity rights, arising in almost all seed transactions over the observation period, and special liquidity for investment guidelines breaches/changes has become almost as universal as more seeders have focused on protecting the seed investment, officials said.
The study did not mention the advent of SEC’s changes to form PF, which require hedge funds to report adverse circumstances to the regulator within a certain time frame. Of course, that documentation applies to more established managers.
Keeping it ‘friendly’
The study also suggests an increase in both “manager-friendly” and “third-party investor-friendly” structures for seed deals. The continuing trends are seeders’ willingness to bear some of the startup costs of the new business. At the same time, terms remain subject to a liquidity profile that is similar to other investors in the fund.
“The data reflects a resilient market despite the economic slowdown in 2022, which managers and investors will surely leverage to navigate evolving challenges in the years to come,” the report concluded.