First loss capital arrangements – like their cousins, seed capital
, acceleration capital and founder share classes
– are a means of obtaining hedge fund trading capital outside of the typical limited partner or investor channels. Generally, in a first loss capital arrangement, a first loss capital provider and a hedge fund manager both contribute capital to a managed account; the manager has trading discretion over the account and bears, as the name implies, the first losses from trading in the account; and the capital provider pays the manager significant fees on net capital appreciation. The chief benefits and burdens of first loss capital arrangements are implicit in the name. The chief benefit is capital, which in today’s environment is increasingly hard to come by – especially for the smaller and midsize managers that typically enter into first loss capital arrangements. (Interestingly, first loss capital is not just hedge fund “venture” money; more established managers routinely access first loss capital for a range of purposes.) The chief downside is that the manager itself bears the loss of its contributed capital, which is typically proprietary or friends and family money. Managers can feel the pain of investment losses in first loss arrangements to a degree that is unfamiliar to professionals accustomed to handling what Justice Brandeis famously termed “other people’s money.” To assist hedge fund managers in applying the typical benefits and burdens of first loss capital arrangements to the facts of their individual circumstances, this article discusses: the definition of first loss capital arrangements; typical structures of first loss capital arrangements (including numerical examples); the identities of first loss capital providers; the “market” for terms of first loss capital arrangements (including losses, performance fees and termination and withdrawal provisions); the rationale, from the hedge fund manager perspective, of entering into first loss capital arrangements; the risks from the manager perspective of entering into such arrangements; and specific pitfalls to avoid when entering into such arrangements. First loss capital arrangements can be valuable in raising capital quickly and developing a track record. See “Portability and Protection of Hedge Fund Investment Track Records
,” Hedge Fund Law Report, Vol. 4, No. 40 (Nov. 10, 2011). But there are quite a few traps for the unwary – and many of those traps can be identified and mitigated through careful legal structuring. First loss capital arrangements, in short, are an area in which considered legal review can yield tangible investment advantages and can avoid structuring missteps.