Some Work of Noble Note

May Yet Be Done

Enter the Hedge Fund, Part II

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I can only hope for additional demonstrations of my own prescience.

peHUB wrote recently about the hedge fund Tiger Global’s move toward investing in technology startups.  My loyal readership will recognize in this statement a clear continuation of an earlier post on Snapchat which discussed Coatue’s movement into the space.  That post looked at how hedge funds, with their large capital pools and lower cost of capital, may be able to “disrupt” the traditional VC model which bundles capital with expertise to then demand a higher return.

Tiger Global is cited along with Altimeter, Coatue, Fidelity, Maverick, T. Rowe, and Valiant, as managers who have invested an aggregate of $2.5 billion in 39 deals last year, up 26 percent from 2012.  For a mostly specious comparison, Andreesen’s latest fund is of $1.5 billion in size.  Granted, a16z will make many multiples more investments than the hedge fund cadre above, but the fact that those funds typically target pre-IPO rounds – i.e., companies that are established, likely to be successful, with significantly less risk than a startup – makes them increasingly meaningful players in the startup ecosystem.

I talked about why this is.  First: valuation.  Hedge funds aren’t underwriting to the PE / growth equity 20% – 25% cost of capital.  They are worlds away from following the boom-or-bust, 10x or no-x strategies of traditional VCs.  Most of them are happy if they outstrip the Dow, which, over time, provides a high single-digits rate of return.  Requiring at most a third the return rate of competitive asset classes, hedge funds can truly outbid VCs and growth equity firms for attractive Valley assets.

Second: entrepreneur friendliness.  Hedge funds have the benefit of minimal governance (again, relative to competitive asset classes).  They don’t join your board prescribing best practices and demanding the cultivation of strategic relationships for a medium term exit (partly because they don’t need the outsize returns that growth equity and VCs do).  While a lot of these recommendations – I believe – are in a company’s best interest, especially with competent investors, many management teams have no interest in such prescriptive ownership.  They’d love to avail themselves of Sequoia’s network or Accel’s “this is what worked with similar companies” guidance; but they’d hate to have those meetings / practices mandated the way they would with the more hands-on investing role that VCs and growth equity play.

Those two factors – higher valuations and more hands-off capital – are impossible to ignore when contemplating the potential role for hedge funds in the Valley.  What about a third factor?

“Tiger’s betting spree comes at a time when many public-market investors believe much of a company’s traditional “pop,” or stock-price appreciation in the days and months after its IPO is less pronounced than in past years. That’s because greater valuations are reached on private markets than in the past.”

It’s an unusually specific factor to isolate – stock-price appreciation in the immediate post-IPO period.  While it’s entirely believable that some hedge funds have strategies built to take advantage of IPO underpricing, the article concluding that those strategies are less profitable now because “greater valuations are reached on private markets than in the past” is only half-stating the actual answer itself.  It hints that it’s not just that hedge funds are discovering new, attractive markets to explore but rather that their old markets are starting to dry up.

In fact, the conclusion there could well be that the private markets are efficient enough to accurately value companies before they go public.  A less benevolent, but equally valid view, is that the private markets are flush enough with capital that they tend towards overpricing assets at an earlier stage making the IPO more fairly priced, rather than the traditional underpricing, and thus forcing hedge funds to move out of the public market realm to make their preferred return profiles.

Ultimately, hedge funds remain the most flexible capital in the market.  They can underwrite to lower rates, they aren’t expected to provide network and leadership, and they can have looser investment mandates from their LPs.  If they continue to become influential players, it would push the market further towards disaggregation of services – capital from expertise.  There’s a lot of reasons to think why this would be the case, all of which are underpinned by the basic principle of comparative advantage.

The only question left – which I can only answer from a theoretical rather than practical perspective so far – is whether entrepreneurs ought to value capital separate from expertise.

Author: AJ

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

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