How to Structure Exit Provisions in Hedge Fund Seeding Arrangements

Some legal arrangements are meant to last in perpetuity.  Other legal arrangements begin with an explicitly finite life.  And yet other arrangements commence with the goal of perpetuity, but only achieve a limited duration.  Hedge fund seeding arrangements fall – or should fall – into the second category: in the better-structured seeding deals, the mechanics of exit provisions are comprehensively described in the deal documents, and understood by the parties prior to the formal commencement of the relationship.  See “Primary Legal and Business Considerations in Hedge Fund Seeding Arrangements,” Hedge Fund Law Report, Vol. 2, No. 38 (Dec. 10, 2009).  Conceptually, seeding exit provisions should balance the goals of hedge fund managers and seed investors.  Managers generally want control and unencumbered revenue streams, and seed investors generally want a return on their investments.  Importantly, over time, these goals need not conflict with one another: seeding exits can be structured in a manner that facilitates a graceful exit by the seed investor, and that maintains the entrepreneurial spirit necessary for continued success by the manager.  The intent of this article is to explain the structure, rationale and context of a number of exit provisions that have actually been used, according to our sources, in seeding deals.  To do so, this article discusses: what types of entities are engaged in hedge fund seeding; the services typically provided by seed investors to hedge fund managers, and the extent to which those services are similar to those provided by prime brokers; the categories of consideration typically provided by hedge fund managers to seed investors; variations on hedge fund seeding arrangements (including “foundership,” founder share classes and acceleration capital); the business case for seeding; the adverse selection argument (and some powerful rebuttals to it); rationales for exiting seeding arrangements, from both the manager and investor perspectives (including a discussion of the seeding provisions of the Volcker Rule); nine distinct approaches to seeding exit structures (including put/call agreements); and considerations in connection with funding buyouts.

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