Why Emerging Hedge Fund Managers Should Consider First Loss Allocations

Whenever a hedge fund manager hears the term ‘first loss’ at a conference, they have a tendency to quickly discover that they need the restroom, or have missed a call; anything to avoid the conversation. It’s not surprising, because starting a conversation with a portfolio manager talking about their losses isn’t always the best way to try and build a relationship.

I prefer to focus on the positives. Maybe call it ‘first gain/ first loss’ or ‘0/80 payout’.

Whatever you think of the name, these allocations are a great way for portfolio managers to build an institutional track record, increase assets under management (AUM), and help accelerate the growth of their hedge fund business. It’s also a great way for established managers to test out new strategies with segregated capital to build a specific track record before raising money in a more traditional management fee/performance fee model, because all of the allocations are placed in managed accounts and in the name of the first loss allocator. The first loss allocator hires the manager as an investment advisor to run their sleeve/strategy on the platform. The manager owns his/her performance.

These types of allocations only work with specific underlying exposures. Public equities, options, futures, liquid bonds & treasuries are products that work well in these structures. Private markets strategies such as private equity, venture capital, real estate, alternative credit, etc do not. Basically, anything liquid and publicly traded, apart from cryptocurrencies, because they are simply too volatile at the moment for the arrangement to work.

Similarly, the approach is important. Long only equities don’t work in a first gain/first loss structure because there is no hedging mechanism that the portfolio manager can employ to mitigate losses. There has to be a hedging component to the strategy, so long/short, market neutral, trend following strategies all work.

The benefits of a first gain/first loss structure are numerous.

First, the payouts can be as high as 85% on a monthly basis on realized or unrealized gains. You read that right – you get paid out on the increase in the value of the account. You don’t have to be a forced seller and liquidate any positions. The payment comes from the first loss provider.

Second, which follows on from the above – you therefore do not have to wait for your yearly audit to get your performance fees. The first loss model provides for a more frequent distribution of incentive fees to the manager.

Third, first gain/first loss allocators often don’t only offer these terms. As a manager builds their track record and consequently their credibility, the chances of an allocation more traditional in structure is increased. The first gain/first loss exists to support new managers, or existing managers looking to build a track record with a new product, but in a way that de-risks the investor.

Fourth, and this is perhaps the main benefit: Partnering with a first gain/first loss investor can show other investors that the manager is confident in their strategy and willing to ‘put their skin in the game.’

The next time that you meet a first gain/first loss investor, don’t rush to the bathroom or reach for your cell phone so quickly. They don’t bite, and the potential upside is significant.

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Lance Baraker is CEO of Positive Gamma. Connect with him on LinkedInhere.