First Loss Capital Model

I found it interesting how little I knew about the structure of ‘prop firms’ from an investor/partner perspective. After talking to some colleagues I’ve pieced together an idea of what it is which I will explain below. But full disclosure, I could have misunderstood the explanation!

The ‘first-loss’ model is very much like a brokerage account but with more leverage. It’s like FXCM for equities. Your primary concern is risk management (you don’t want to get FXCM’d or Madoff’d), amount of leverage available and trading costs. Once your equity is drawn down, your account gets margin called and likely liquidated. So if you deposit $50k, get $500k in capital but lose $50k P&L, your account is shut down by the fund. Keep in mind the difference between 100% loss and 10% loss. But what if you are the owner of the firm?

Typically someone will deposit say $10MM, either their own money or raised from investors and become the GP. They will then seek out additional investors who will deposit say $100MM into the same account. The second group are the LPs. The LP cash is NOT TO BE RISKED. Any losses will be absorbed by the GP FIRST and there is likely an understanding that should the GP equity be completely depleted, the positions will be liquidated and the initial 100MM will not be touched. In return, the LP will receive a guaranteed return backed by the revenue (P&L, commission, etc) before the GPs are paid out.

Here’s a quick example, Owner X raises $10MM as GP and Investor Y will invest $100MM. A Prime Brokerage account is opened and $110MM equity is deposited. They provide 5x on it, so through the magic of leverage you now have a $550MM hedge fund! Hire a bunch of guys, dole out the $550MM to each. Let’s say you make 10% return from the P&L cut and charging commission/financing costs or $55MM. The LPs are guaranteed 10% before GPs are paid, therefore they receive $10MM and the other $45MM goes to the GPs. Not too shabby.

But let’s say after 3 months, the firm suffers a $9MM loss. While the prime brokerage still may see $101MM equity and the capital available might be $505MM, the firm only has $1MM of equity to play with. They will either decide to fold, or severely cut positions as they can only absorb $1MM more in losses. On $505MM book size, a $1MM loss is a few ticks!

So in essence, a prop firm that requires no capital is simply allocating some of the GP money into your account as well as keeping a larger percentage of your profits. There really isn’t much difference between prop and ‘first loss’ other than where the initial deposit comes from structurally. Obviously payouts are quite different. It is interesting to see Leucadia getting into the game but from an LP standpoint, it’s actually quite an interesting investment. The principal is mostly secure with potential for 10% dividend, it’s similar to issuing a bond and there is nothing to say the LP can’t invest some money in the GP as well to retain upside! From the article, Leucadias investment is prefaced on the ability to raise $400MM of outside capital. I would imagine that $400MM will be ‘first loss’ capital. likely HF guys who’ve managed to raise $10 or $20 but not enough to be self sustaining. They can offer space, back office, compliance, marketing, etc and turn a 10MM fund into $50 or $100MM overnight.

Incidentally that is probably why a majority can’t or won’t pay salaries, they simply do not have the cash! There are pros and cons to the model, mostly revolving around the issue of leverage, it’s probably situation dependent. I just wondered where the large amount of capital came from, initially I thought it was simply from borrowing (and in a way it is) but more like a firm issuing a bond. Food for thought!

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~ by largecaptrader on February 5, 2015.

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