Posted by a StreetofWalls Contributor:

Chicago-based Citadel, LLC has finally spun out one of its hedge fund incubation platforms, despite an environment considered by many to be unfriendly to seeding strategies.

Encompass Capital Advisors, LLC completed its personnel realignment at the end of Q4 2011, and will begin formally trading with about $100 million in February 2012. The firm itself is a direct outgrowth of Citadel’s alternative asset management arm, which is headquartered in New York. The unit’s first incubation platform, PioneerPath Capital, launched in February 2007 and initially managed a long/short energy and industrials portfolio. Citadel added Surveyor Capital in 2010, and the two platforms started managing a range of equities.

This move represents the first successful spin-out by Ken Griffin’s renowned hedge fund. Encompass Capital’s charter CEO, Todd Kantor, began organizing the team in Q4 2011 while still working as a PioneerPath portfolio manager. His email to colleagues and professional contacts stated that the firm would focus on global, long/short energy and energy-related stocks. Since he employs analysts who still cover steel and other industrials, it appears that Kantor’s sector focus may be pretty flexible. Overall, though, it looks like a lot of oil and gas, coal, and alternative energy.

This spin-out gives rise to some important questions. What becomes of the remaining platform, Surveyor Capital? When will the next spin-out be? Will Griffin make New York his permanent Cape Canaveral for seeding platforms? What happens if Encompass folds?

Although what was left of PioneerPath was absorbed by Surveyor, and seems to be operating the same way it has since its inception, there are indications that another spin-out is coming soon. Portfolio manager Clint Murray is currently building out “Lodge Hill Capital,” which should be ready sometime closer to Q2 2012, and will likely invest in the consumer sector. If Encompass and Lodge Hill do what Griffin hopes they’ll do, we could be looking at a revolutionary new type of hedge fund. Citadel LLC is acting as a pyramid fund, of sorts – basically seeding new ventures with accumulated wealth and reaping the benefits as they grow on their own. The pyramid is shallow because the spin-outs don’t spin out anything themselves, but that’s not to say they can’t. Honestly, the sky is the limit.

An added bonus to the small size of the spin-outs is that they may be able to pass under the radar of the SEC. Anyone who has read the latest slew of filing nightmares headed our way knows that size (whether we’re talking about AUM or personnel) can draw a lot of unwanted attention. If Griffin is worried about filing proprietary information on a Form PF, having a labyrinth of legal entities might offer some haven for retreat. Corporate and capital taxation might similarly benefit from legal ambiguity.

We won’t know exactly how successful Citadel’s methodology is until we see a filing of some kind. Until then, we’ll have to navigate the firm’s notoriously clandestine nature (an officer there once told me “I admire your tenacity, but we’re a private company and there’s no way in hell you’re getting that information” ). Given that Citadel’s Kensington and Wellington funds are up more than 17% as of COQ4 2011, Griffin can afford to experiment with his New York arm. If everything stays sunny in Chicago, expect those New York seeds to get a whole lot more fertilizer.