Hedge Funds, and the Future of Investing

silicon-valley-night-hedgethink Hedge Funds, and the Future of Investing

Traditionally, hedge funds have invested in public companies, but with the post Dodd-Frank regulatory burden weighing heavily around the necks of fund managers accustomed to making big bucks from derivatives trading, many have started to look elsewhere in search of market-beating returns.

By elsewhere, we mean private companies. Companies that don’t have to report their every move to stock market investors – and in many cases, companies that really haven’t been around that long. This, according to many knowledgeable bods within the investment industry, is where the real money is to be made, especially now that many hot startups are eschewing the obligatory IPO in favour of hunting out less demanding sources of capital.

Up until recently, startups – particularly in the tech sector – looked almost exclusively towards venture capitalists for funding. There were, and remain, many advantages to this approach. Venture capitalists don’t make risk-adjusted investments – they just make risky ones, and try to help out where they can in order to smooth the path to success for the young companies that they invest in.

Usually, they come from entrepreneurial backgrounds themselves, and know what it takes to get through the troublesome early stages of running a company. Also, they often have much better contacts than the people they invest in, thereby adding value to the fledgeling firms they own activist stakes in.

Hedge Funds: A Viable Alternative to Venture Capital?

Accepted wisdom has it that hedge funds are the polar opposite of venture capital firms. For starters, they have the sole aim of making money, and making it within an acceptable time frame. They will take a punt, of course, but if it doesn’t come off, they’ll be the first ones to dump their shares or asset-strip a firm in order to reclaim some of their initial investment. But while they might be all too keen to take an activist position when things are going badly for a company, it’s not their business to intervene at a stage when a company is still growing and needs a leg up.

These are the main reasons why startups, historically, have tended to shun hedge fund money in favour of VC funding. Yet, in recent years, the map has been redrawn in dramatic fashion. Perhaps the watershed moment came when Snapchat – one of the big tech buzz stories of recent times – shunned a $3 billion buyout offer from Facebook in favour of a $50 million round of funding led by hedge fund Coatue Management, rather than seeking out further VC funding.

This deal was, in fact, symptomatic of a growing trend for tech startups taking money from hedge funds rather than going the more well-trodden VC route, and there are several advantages to this approach. Firstly, hedge funds tend to be willing to put in more money, with fewer strings attached, than venture capitalists. Also, they are willing to pay up front, rather than offering the money conditionally in stages as is the norm with venture capital. Basically, if you are a tech startup that feels they need big money in a hurry in order to achieve your aims, then taking it from a hedge fund would seem to represent the path of least resistance.

A few years ago, hedge funds just weren’t interested in tech startups. Having had their fingers burned during the dot com bubble, the prevailing attitude was that this was something that was best left to the paternal urges of venture capitalists.  Yet, with VCs making blockbusting profits from businesses such as Facebook and Twitter in exchange for comparatively small investments, it wasn’t too long before hedge fund managers started to sniff a missed opportunity. Soon, tech fundraising get-togethers were stuffed to the gills with hedge fund managers eager to get a piece of the action, and increasingly, they got it.

silicon-valley-night-hedgethink Hedge Funds, and the Future of Investing

SurveyMonkey received over $400m in funding from hedge fund investors

The recent history of tech fundraising is littered with examples of hedge fund money coming in where VC funding would have been expected. For example, when online survey firm SurveyMonkey went out to raise an $800 million funding round, it was led by former Tiger Global protege Chase Coleman. Other high-profile examples include a $30m investment in Hubspot by hedge fund Altimeter Capital and other institutional investors, and an $85m funding round by note-taking app makers Evernote from AGC Equity Partners/m8 Capital and Valiant Capital Management.

A Shift in the Startup Investment Landscape

What we are witnessing with this apparently sudden shift in the way that startups are being funded is in many ways a symptom of changes in the nature of startup investments. It’s becoming a much more transparent and open landscape, and the era of secretive, behind-closed-doors dealmaking is becoming a thing of the past.

This has, in part, been driven by the proliferation of equity crowdfunding sites such as AngelList and OurCrowd, which have helped to democratize the flow of money towards tech startups. With internet, and in particular, business social networking technologies, any investor can come across most of the same deals that are being put towards institutional investors. Equity crowdfunding, coupled with the power of business networks such as LinkedIn, have the power to transform the armchair investor into a venture capitalist.

This trend has had a knock-on effect on the behaviour of venture capitalists, to the point where obtaining crowdfunding has become, in many cases, a prerequisite for obtaining bulk funding from risk-averse investors. In today’s market, if you can’t convince a bunch of low-net-worth speculators to buy into your idea, then your chances of attracting funding from a well-heeled VC or hedge fund investor will be much slimmer. Basically, obtaining crowdfunding is seen as a method of showing that your business idea has legs, and is therefore much less risky than something that hasn’t gone through this process.

This move towards inclusivity has also been happening at a legislative level, with initiatives such as the 2012 JOBS Act opening up private investing to a much wider array of investors. Keeping a lid on a good investment idea has become much harder, for a variety of reasons, but this is only helping to fuel innovation and add liquidity to the markets. What’s more, this isn’t just happening in the startup world – it can also be observed in other markets such as real estate and other alternative assets.

One of the side effects of increasing the pool of potential investors is that valuations are being pushed upwards. More competition means that the best companies will have more investors fighting over them, and this drives up their valuations. This, of course, introduces more risk to the equation, and for every hot tech startup that has millions ploughed into it that then goes on to a stellar IPO, there will undoubtedly be several that crash and burn, taking the investors’ money with them. There may soon come a point when the flurry of investor interest in tech startups will once again cause the bubble to over-inflate and burst, but at the moment this seems to be a long way off.

As a general rule, the easier and more liquid an investable asset is to trade, the more likely they are to be owned by a larger population. Investing in public companies is comparatively easy for the average investor, with special tax allowances for pension investors and online brokers that allow anyone to buy and sell shares at the click of a mouse.

As it stands, private companies are treated very much as being alternative assets for high-end investors, or at least those who have a very high tolerance for risk. Yet, in the future, we could see investments in private companies taking their place alongside publicly listed stocks, bonds, and commodities as a core asset in long-term retirement portfolios. Of course, they will always be one of the most risky types of investment, but the potential returns are such that you might only need one or two winners in a whole basket of losers to turn an overall profit.