Some Work of Noble Note

May Yet Be Done

Venture Capital, Hedge Funds, and the Efficient Markets Hypothesis

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Leena Rao at TechCrunch recently wrote about San Francisco-based hedge fund Coatue Management investing $50M in Snapchat.  There’s so much subtext in this one deal to help inform thoughts about the broader Venture Capital model.

What’s telling about Snapchat’s recent Series C is the following:

  1. The round had only one investor (rather than a more common lead investor, with participation from other new or existing investors)
  2. Fundraising gap. The Company was reportedly seeking up to $200M but this round represents just a quarter of that.
  3. Valuation. VC Experts reports the valuation could be up to $2B (vs. rumored Facebook and Google valuations at $3B and $4B, respectively)
  4. Coatue’s low profile. According to Crunchbase, Coatue has only one other investment, a $45M Series D in HotelTonight, made just a few months ago. They weren’t even mentioned as the investor in the official announcement. There are rumors that Coatue participated in a 2012 Box round as well.

The four points above paint a picture in my mind. Snapchat is not close to being worth $3B or $4B to a financial investor,1 however, the Company did need to raise capital and the team didn’t want to quit their jobs just yet. Hence, they turned down Facebook and Google and looked to raise from a financial.

Snapchat’s best valuation came from a hedge fund and that ~$2B valuation was likely far higher than what any other firm was willing to invest at. Why? Coatue was the only participant in the round even though they only put in a quarter of what Evan Spiegel and team seemed to want to raise. The other existing investors didn’t want to commit further capital at that $2B valuation and no new ones did either. There was room to raise more and yet the round stayed small.

In summary: a hedge fund invested in the hottest startup in tech at a valuation that no other VC wanted to touch. What does this mean?

Cui Bono?

I’m not sure what value Coatue is adding to Snapchat besides providing them with mute money. Given that Coatue is a hedge fund, its website is unsurprisingly uninformative. Its LinkedIn profile does list as an employee someone who is a “Board Member and Executive Coach.” Coatue may have brilliant operational expertise and a network to rival Accel’s, but they seem to maintain an awfully low profile for anyone to draw that conclusion. So why did this deal happen? Entrepreneurs talk a lot about wanting access to a great network and operational brilliance of some of the world’s smartest investors. If Coatue isn’t providing either, is “dumb money” (or, at least, mute money) all Snapchat really wants? And if so, should Venture Capital be concerned about hedge fund disruption?

Sure. There are a number of parties that would benefit from hedge funds entering the early stage tech investing. Startups themselves get access to a much larger pool of capital from which to raise, and arguably a better sort of capital, too. Why better? Hedge funds underwrite to a much lower cost of capital than VC firms. As a result, startups get not just better valuations but lower pressure investors as well. The VC model is such that they’re successful if one of 10 investments is a home run, even if the other nine are complete busts. As a result, VCs are biased towards pushing their startups to take bigger risks, and VCs are oftentimes said to abandon investments that aren’t going to be their 10-baggers.

Hedge funds meanwhile get to tap another vast market, and one which could provide markedly higher returns for them. They can also take advantage of cross-informing their investments in certain sectors by having diligence exposure to both the public and private side. (Rao points out that Altimeter has been doing this in the travel sector).

Anyone who has read Andy Dunn’s famous “Dear Dumb VC” post can appreciate how much entrepreneurs dislike investors “meddling” in their company. They may want a vast network and brilliant insights, but only when they ask for it – not when the investor thinks they need it. Dunn may be an extreme version of an otherwise prevalent mindset that investors ought to provide capital and then get out of the way. Hedge funds, since they aren’t built to take on operational leadership roles, can provide capital and then just step back. What they lack in network and solicited guidance can be provided by other sources.

Disruption to the VC model

Who gets hurt in this model is the traditional VC. One investor quoted in Rao’s piece identifies the hedge fund phenomenon as “part of a greater trend of the unbundling of company building, which VCs tend to be good at, from actual capital.”

In other words, the industry of providing capital is being disrupted by the same principles of competitive advantage that Adam Smith observed in his Wealth of Nations. Rather than have one player in the ecosystem provide both capital and expertise, the capital providers can focus on providing capital and the experts can focus on providing expertise and networks. This disaggregation allows startups to value money and expertise independently, presumably leading to more efficient distributions of those goods which the market wants. It’s the invisible hand.

The quick argument is that the experts won’t provide expertise for a fee that doesn’t let them partake in the upside of their clients. Perhaps. But if startups are consistently finding higher valuations from investors that want to be mute – many of whom will end up building their own networks in the space as well – VCs may not have a choice. Sitting on a few hundred million dollars and increasingly finding themselves overbidding (or being outbid), VCs won’t make the same returns their LPs have expected and they’ll find themselves with an adversely selected portfolio of assets.

Conclusion

Leena’s story highlights a number of other hedge funds that are active in private market investing. Tiger Global (Warby Parker, Flipkart, Survey Monkey, and One Kings Lane) is the first example that springs to mind, but she also references Valiant Capital (Pinterest, Dropbox, Evernote) and Altimeter (HubSpot, MongoDB).

Snapchat, as one of the most high profile coups in early stage tech investing, may be the bellwether for a much larger disruption to come.

 

1. Quick aside: financial investors are firms that make investments in assets purely for the financial gain they would see upon selling the asset some period of time later and intermittent dividends and similar vehicles. In contrast, strategic investors are firms that make investments not to flip them a few years down the road but because the assets are core (or relevant) to their everyday business model. Financial investors: VC, private equity firms, and hedge funds. Strategics: Industry players.

 

 

 

Author: AJ

I'm an education enthusiast, growth equity investor, and MBA student at Wharton.

2 thoughts on “Venture Capital, Hedge Funds, and the Efficient Markets Hypothesis

  1. Pingback: Will VCPE Jobs Be This Popular in 2020? | Some Work of Noble Note

  2. Pingback: Enter the Hedge Fund, Part II | Some Work of Noble Note

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