One new funding mechanism in the hedge fund industry is a concept called “first – loss capital.” This process is supposedly available to small funds that are looking to grow assets under management so long as they are willing to accept a significant amount of capital segregated in a separate account structure with a variety of conditions imposed.

The process works in the following manner.  Initially, the investment enters the fund, and is earmarked in a separate account.  As part of the agreement, the manager invests a certain amount of its assets into this account as well.  The manager’s capital is the first capital at risk if there are any losses in the separate account, and all of the manager’s capital will be lost prior to any investor funds being drawn down.  Moreover, the investor has the opportunity to withdraw its funds if it deems it necessary.

There are several problems with this process including that other investors in the main fund are undoubtedly at a disadvantage because the manager is now concerned with avoiding any losses in the separate account.  Essentially, this creates a short-term scenario to avoid losses to the separate account while the long-term investors suffer.

We have found no regulatory or statutory guidance on this particular funding option, and those who pursue it should be very cautious.