Through these boutiques (essentially, small investment firms) his clients would provide the seed money a talented trader or portfolio manager needed to launch a private equity or hedge fund. The manager would bring in additional investors and charge the usual fees. In this way, Elkus’s family office clients gained access to the investment strategies they wanted through funds specializing in, among other things, real estate, leveraged buyouts and arbitrage investments. As stakeholders in the boutique firm, as well as investors in its funds, they were doubly rewarded if managers prospered.

What was at that time an exotic and daring strategy has become more common, though these days the attraction between aspiring fund managers and family offices is mutual. The number of individuals, families and family offices that help new funds get started is unknown. Observers, however, say that new venture capital, leveraged buyout and hedge funds often prefer seed money from family firms to that of institutions such as pension funds and university endowments. Unlike institutions, family firms are not required to invest billions of dollars at a time or answer to their constituents for results each quarter. While they often do expect favorable treatment, family firms will not demand the onerous terms that institutions do—such as wanting to both be the largest investor and have the right to withdraw money at any time—that can scare off other investors.

TOP VIEW By providing seed money for start-up funds run by up-and-coming managers, family offices can get in on the ground floor. This strategy may require more hands-on involvement in the management of the fund, but under the right circumstances, the rewards can be sizeable. However, experts caution that the ultimate success from the family office’s point of view hinges on how well it negotiates the terms of its commitment to the fund, and to the manager in charge.

Often, the families that start a new fund know the aspiring manager involved. Kristen Powers, senior relationship manager for the Threshold Group in Portland, Ore., a family firm for the Frank Russell family and four others, notes, “I would say 90 percent of our relationships [with new funds] are with people who have been associated with the Frank Russell Co. Our [founding client] has worked with the person, knows what that person’s skill set is and believes in the strategy.”

Additionally, many affluent investors like the opportunity to get into a promising fund as early as possible, believing that the first few years, when the fund is still small and nimble, are often its best. “Smaller funds can build a position quicker and get out of something quicker than a big fund. Sometimes a good opportunity won’t make a significant difference in the returns of a big fund the way it will in a smaller fund,” says Laurence Cheng, CEO of Capital Z Investment Partners, a fund in New York that specializes in seeding new investment funds.

Priming the Pump
Managers often want the family firm that seeds their fund to commit 10 to 15 percent of the minimum amount they need to launch the fund. For private equity, that could be less than $10 million, but for a hedge fund it might be $25 million or more. A hedge fund manager might also ask for money to finance his operations for a year or so.

In addition, unlike private equity investments, in which all the investors pay their committed money and take their rewards together, hedge funds are ongoing, with investors coming in and out as often as monthly. The manager of a new hedge fund needs time to invest money and build positions. During this early growth phase, he does not want investors getting cold feet and pulling out before he has built momentum.

Consequently, he will expect the first family firm in to lock up its money for a minimum period. The actual length of the commitment is negotiable, but according to Elkus, two or three years is common.

From Your Side of the Table Five essential questions to ask about seeding new investment funds: 1. How does this new fund’s strategy fit with my overall investment plan? 2. Do I trust this manager’s ability to execute that strategy successfully? 3. Do I believe this manager can successfully raise money and handle the day-to-day work of running a fund? 4. How will I protect my interest if the manager and I disagree down the line? 5. Are my returns in proportion to the risks of backing an unproven manager?

In exchange, family office investors usually receive a share of the boutique firm’s annual management fee (which is typically 1.5 to 2 percent of the fund’s assets) and incentive fee (generally a 20 percent share in the investment gains). This happens most often with hedge funds, and is becoming more common in private equity. Typically, the family firm’s share of these fees ranges from 10 to 50 percent, depending on how much it is investing and the professional reputation of the new manager.

Family office investors still pay the management fee like everyone else, but ideally the amount they receive back will eclipse what they pay, Elkus explains. Better still, a share of that incentive fee can nicely plump the family’s returns. For example, David St. Pierre recently launched Legacy Capital Partners, a real estate investment fund in Cleveland. An affluent investor who liked the idea of a real estate fund agreed to seed it, St. Pierre recalls. The investor committed a little over 5 percent of the $44 million Legacy raised. However, because he committed money before anyone else and introduced the team to other investors who then committed money quickly, he also received just under 10 percent of the firm’s fees.

If, for example, that fund generates a 15 percent return, or $6.6 million, in a year, Legacy keeps 20 percent, or $1.32 million as its incentive fee. Those who seeded the fund will get 10 percent of that, or $132,000, on top of whatever they have earned as investors in the fund.

Venture firms, by contrast, have resisted giving a share of their profits or fees to the first family firm to commit money. Instead, they offer the family the opportunity to invest additional money directly into some of the fund’s portfolio companies. The idea is that the venture fund managers see dozens of companies every day and pick the best ones for their fund. They then cherry pick the most promising and let the family office invest alongside them.

“We know families who will put $3 million to $5 million each in a dozen venture firms,” explains Alan Houghton, chief investment officer for Shelterwood, a family office in New York. “Then they will earmark several million more to invest in the 10 best companies the funds invest in.”

Inside Information
Family offices also provide other intangible support in exchange for those nonfinancial perks that allow them access to the fund’s inner workings. For example, some funds allow an individual from a family office to sit on their advisory board if they think that person has useful expertise or contacts. “We wanted [seed] investors who could provide things like access to potential deal opportunities,” says Michael Cochran, an attorney in Atlanta who spent six years running a leveraged buyout fund there. “Investors can also bring investment judgment [in specific areas].”

In exchange, the advisory board members get to see the firm’s day-to-day workings—the daily trades, strategies and information most investors do not have.

The board also has some ability to influence the direction of the young fund, which can be important if it underperforms or strays too much from its intended strategy. Cochran has a client in his law practice who “doesn’t like to invest in [any new funds] where he doesn’t have a say. He has been a passive investor before and has gotten burned.”

However, Elkus warns that there is a downside to getting intimately involved with a fund. “You’re no longer an anonymous investor in a faceless group. It will be harder to pull your money out from under this manager and the other investors,” he says.

Family offices that do not want the commitment of being on the advisory board often negotiate for access to the fund manager. He might provide input into other deals the firm is considering or periodically talk to the family and staff about what investments he has made and why.

“We’ve negotiated educational opportunities, usually meetings where the managers will talk to the people in our office about how they pick deals,” the Threshold Group’s Powers says. “It’s also been helpful for us to learn things like how they do due diligence on certain kinds of companies.”

The Rookie Factor
Former family office president and boutique firm investor Bill Elkus warns that there are risks inherent in backing a rising star who has never actually managed his own fund. If he repeatedly underperforms, it might be hard to get rid of him. “He’ll rely on this contract to keep his position,” Elkus says. However, if the fund takes off with huge returns and investors lining up to get in, “he’ll try to renegotiate that contract with you,” specifically, he will want the family office to accept a smaller share of his profits.

According to Jeff Tarrant, the president and chief investment officer at Protégé Partners, another New York firm that seeds new funds, it is essential that family office investors plan for those possible failures or success in the contract. For a hedge fund, investors should lay out how long both they and the manager are obligated to stick around, and specific reasons why each might be released early. These could include performance targets for the manager. If the fund really takes off (along with the manager’s ego), “you might want to give him the option of buying you out and determine the terms ahead of time,” Tarrant advises.

With LBO and venture funds, family office investors should agree at the outset whether coinvesting rights or a share of the profits apply to subsequent funds or just the first one. They should also clearly establish with all parties that being a seed investor in the first fund will assure them a place in future funds. Elkus notes that he has seen family offices do both well and poorly at seed investing. The factors that determine success include the family’s background and risk tolerance as well as the financial knowledge and connections that they and their office staff bring to the table. “It’s more hands-on and intense than just being another investor in a fund, so you have to be interested in that experience,” Elkus says.

Eileen P. Gunn writes about personal finance, executive careers and real estate. epgunn@hotmail.com