First loss platforms, investment vehicles designed to facilitate allocation to hedge funds while limiting downside risk, are not new entrants to the hedge fund world, having been around in some form since the early 2000s. However, increased interest in these niche structures has been seen from investors and the media of late, driven by reports of participation by big names such as Paulson & Co and Hayman Capital.
These platforms, which typically see interest from family offices and other smaller hedge fund allocators, seem attractive for several reasons. These include consistent (at least to date) mid to high single digit returns, few down months and better alignment of interest between managers and investors, despite significantly higher performance fees. The alignment of interest is due to the manager, as the name suggests, absorbing first losses, typically up to 10%. In addition, the managers typically running first loss capital are smaller emerging managers or traders that some investors simply cannot gain access to in any other way.
This sounds like a win/win situation, but how, in an increasingly challenging hedge fund environment for the hedge fund industry, are these platforms able to generate steady returns, with limited, or no, downside? And what are the risks of allocating to them?
