For hedge funds, seed capital is the new normal

May 31, 2011, 9:37 PM UTC

Even the most pedigreed hedge fund managers are considering seeders since the financial crisis has made investors wary of putting money with managers striking out on their own. 

FORTUNE — Hedge fund pioneer Michael Steinhardt has criticized hedge fund managers for becoming nothing more than asset gatherers. Steinhardt told CNBC this spring that managers today seem happy to perform just well enough to stay ahead of the market, and make their real money by growing assets and living off of the management fees. He says the business is turning into a compensation scheme, which has encouraged big funds rather than killer performance.

Hedge fund seeding is a business that some observers (well, cynical observers) think gives investors a chance to partake in the compensation scheme that Steinhardt disdains, but that has made people a lot of money. Afterall, the management fee structure allowed even mediocre managers to profit so long as money rolled into their firms. Who wouldn’t want in on that?

A seed investment, as you may have gleaned, is an injection of early stage capital. A hedge fund seed is large enough to help a manager get off the ground; and some seeders also kick in marketing, risk management, and back office help. If the investment is from a prestigious firm – i.e. Larch Lane, Reservoir, Protege, Blackstone (BX), or SkyBridge – the seed can act like an early imprimatur of success.

The seeded enter into a relationship that operates like indentured servitude lite. In exchange for money, marketing, and (sometimes) prestige, seeders get some combination of an equity stake in the business and a cut of the fee income generated by the fund for an agreed upon period of time.

Before the financial crisis, the most talented managers (or at least those with the best track records) didn’t need to be seeded. They were easily able to raise big money (about $1 billion for a launch vs. the $100 million that is now considered a great raise) without any help. At the height of the hedge fund boom, managers who relied on seeding platforms were sometimes thought of as the sort of guys who couldn’t succeed on their own.

Now a Larch Lane report says that even the most pedigreed managers are considering seeders, since the financial crisis has made investors wary of putting money with managers — even established ones — just striking out on their own. It’s high risk to put a bet on an emerging manager, regardless of what kind of track record he or she created while at a prop trading desk or at another hedge fund. The report adds that seeders are also in a position to negotiate even better terms for themselves than before.

In short, there’s a glut of funds who want money. “I can show you countless managers who looked good on paper, whose baseball card so to speak looked great, who blew themselves to pieces the minue they had contact with the market,” says SkyBridge founder Anthony Scaramucci. “You have to find managers who have what Simon Cowell calls the X-factor.”

I ask Scaramucci what I’d have to give up if he seeded my future firm (you know, when I unleash my X-factor). After reassurance that my boss (and Scaramucci’s Wall Street 2 partner in cameo crime) would be a part of the package, Scaramucci says he would probably provide about $75 million, fund raising help, and a spot in his SALT conference line up. In exchange, SkyBridge would want about 25% of the fee revenue generated by Fortune Magazine Capital Partners (FMCP!).

This is how the arrangement more closely aligns SkyBridge’s risks and rewards with mine. If the Fortune hedge fund rockets from $100 million in assets under management to $1 billion, it would not only be the Cool Runnings of hedge fund stories, it would be a huge pay day for the management team and the seeder. Scaramucci and I could happily collect the 2% fee charged on the burgeoning assets, and use the growing pile of cash as some nice rainy day money should I not actually perform all that well on a long term, annualized basis. Since SkyBridge is a well known seeder, that stamp of approval would hopefully beget more limited partners and create the bloated asset base that will make everyone rich even if I don’t knock it out of the park a la Steinhardt’s famed 24% average annual returns over 28 years.

This is not to say, of course, that seeders aren’t genuine in their desire to find the very best managers. It is only to note that seeders can still make money on mediocre managers if those funds manage to gather assets during a boom.

So as the word ‘seed’ keeps popping up in hedge fund news, at industry conferences, and in conversations with institutional investors, know the trend is doing more than helping nascent firms or filling in the gap between hedge fund LPs and fledgling managers. Banks like Goldman Sachs (GS) and Morgan Stanley (MS), private equity firms, and more big investment platforms are raising money for seeding funds to be on the right side of what motivates hedge fund managers to hang a shingle – the ability to lock in some cash as a rising tide lifts all boats and money roars back to the asset class.