Q. Its an awfully tough environment for new hedge funds, without a track record, to raise capital… but this is one pretty common way for them to do it. How does it work?
A. Yep, this idea was pioneered by a firm called Topwater several years ago, and has now become reasonably common way of getting a new fund off the ground. The basic idea is that the new manager puts in, say, $1 million into something called a first loss account. Then, the funder puts in $9 million on top of that. All of the first losses are subtracted from the manager’s $1mm, instead of being divided pro-rata across the $10mm total. That’s the bad news for the manager. The good news is that he gets more than 20% of any gains– up to 50%– on the whole $10mm.

Q. So… the net economics work out how?
A. Well, on that example, if the fund is down 10%, the manager is wiped out and the funder probably pulls the plug on the arrangement. But if he’s up 10%, he makes $500,000, a 50% return on his own investment!

Q. Talk about pressure! Sounds like a good premise for a reality show.
A. Yes, and you wonder how that impacts the trading decisions, frankly. Of course, managers don’t love doing it this way, but it does allow them to generate a real track record with significant dollars in a way they might not otherwise be able to.

Q. Well, that’s a good question. What other sorts of structures are out there to attract funding to new managers?
A. The most common is a “seeding” arrangement, in which the manager gives up a piece of the “GP”– the management company that runs the fund and earns the fee– to the group that does the seeding. That is, the seeder will earn a chunk of the manager’s “2 and 20” for all subsequent capital the fund raises. Naturally, managers don’t like that either – they don’t want to give up so much of their long term upside for running the fund to someone just in exchange for making an investment. So for them, a “first loss” account might be worth a look.