First Loss Capital: Definition, Benefits, & Pitfalls for Fund Managers & CTAs (2024)

Hedge Fund Managers and CTAs have always sought innovative ways to maximize their trading capital and improve their returns. One such approach that has gained popularity in recent years is the First Loss Capital (FLC) Funding arrangement. In this introductory article, we will explore the definition of First Loss Capital, the benefits of obtaining FLC funding, the rationale for entering into a FLC arrangement, the typical structures under a FLC arrangement, and the potential pitfalls and risks for both the fund manager and the funder. Please note that this is a strictly introductory article to a complex subject.

Definition: First Loss Capital refers to a type of funding arrangement where a capital provider typically allocates to a separately managed account traded by the manager. The manager is required to provide their investment capital of 10-20% of the total managed account which is usually matched by the FLC Provider. The manager receives an industry high elevated performance fee of 45-80% of trading profits with the higher percentage payouts often attracting a management fee accruing to the FLC provider, with the understanding that the fund manager absorbs the first losses, should these occur.Typically an 8-9% max drawdown will trigger liquidation in the case where the manager has contributed 10% of total allocated trading capital.

Benefits: There are several benefits to obtaining FLC funding for a hedge fund or manager. Firstly, it allows the fund manager to increase their trading capital and thus, potentially, their returns, particularly with the high performance payouts. Secondly, First Loss Capital Funders also provide managers with access to institutional grade infrastructure and service providers, elevating the suitability of managers under institutional investor mandates and capital percentage of fund restrictions. Thirdly, it can help the fund manager attract new institutional investors by demonstrating the manager's commitment to risk management and transparency and their ability to perform with scaled capital.

Rationale: From a fund manager's perspective, entering into a FLC arrangement is a strategic move that can bring several benefits. By obtaining FLC funding, the fund manager can increase their trading capital, extend their existing trading strategies and market diversification, depending on core strategy, and potentially boost their returns. Additionally, increasing AUM for the fund manager will often put them on the "radar" of institutional investors and allocators, instill confidence in potential investors and demonstrate the fund manager's commitment to risk management amid scaling.

Structures: There are various structures under which an FLC arrangement can be made. In the most common example, an investor providing FLC may provide a fixed amount of risk capital to match that of the manager, usually as a managed account with the investor having full discretionary authority should agreed downside risk triggers be met. The terms and conditions of the FLC arrangement, such as the duration, risk parameters, trigger terms and the return expectations, are agreed upon between the fund manager and the investor.

Pitfalls and Risks: While there are several benefits to obtaining FLC funding, there are also potential pitfalls and risks for both the fund manager and the funder. From the fund manager's perspective, the FLC arrangement may limit their flexibility in managing their fund, there may be manager concerns regarding proprietary alpha generating strategies amid the full transparency, and fears of strategy replication as the investor may have a greater say in the fund's investment decisions due to the arrangement usually being structured as a managed account with full oversight. Liquidation impact and market liquidity risks depending on strategy, markets traded and position size amongst other factors in the event of a mandatory liquidation event should thus be fully considered.

Typical Manager Criteria for First Loss Capital Consideration: Qualifying fund managers and CTAs who have a 2-year minimum portable and verifiable track record, trade very liquid, readily marked-to-market listed markets, have low volatility returns with truncated risk, and who are managing a minimum of $1 million in risk capital, are usually considered.The pedigree, talent, ability to generate alpha and key-man risks will also be carefully assessed as part of a thorough due diligence process.

Conclusion: First Loss Capital is a strategic funding arrangement that can bring significant benefits to hedge funds, fund managers and CTAs that are fully prepared to take their operations to the next level. However, as with any investment funding deal, it is important to carefully consider and weigh the potential risks and benefits for each party before entering into such an arrangement.

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INVITATION from FIRST LOSS CAPITAL Services to Qualifying Fund Managers:

We are currently working under a mandate from First Loss Capital Providers seeking L/S Equity, Market Neutral, Arbitrage, Global Macro and Energy Fund Managers to fund.

Managers that meet the criteria mentioned in the Article above are encouraged to submit their fund details, including an overview, strategy description, monthly track record, manager pedigree, and related marketing documents, for consideration.

Please visit https://firstlosscapital.com/ or call +1(713)449-6202 or email sam@firstlosscapital.com

Let us help you take your trading capital, returns and fund to the next level.