Hedge Funds Increasingly Investing in Tech Startups

Startup-Domination-Map- Hedge Funds Increasingly Investing in Tech Startups

Startup Domination Map

One of the major trends in hedge funds over the past few years has for hedge funds to invest in tech startups, which has traditionally been the preserve of venture capital funds. One of the most high profile cases in recent times was that San Francisco hedge fund Coatue Management was the backer behind Snapchat’s $50 million round of funding, as opposed to any of the leading VC firms.

The idea of hedge funds moving into traditional VC territory has, naturally, been met with some suspicion among those in the venture capital community. Hedge funds are widely viewed among venture capitalists as being the antithesis of the kind of patient, supportive early stage investors that tech firms need when they are finding their feet. Yet, many tech startups are choosing to take this route over accepting VC funding, and there must be a reason for this.

Coatue is just one of many cross-over funds (funds that cross over from the private to the public markets) to have entered the tech investment ecosystem in recent times. One of the pioneers of this approach was Integral Capital Partners, which was founded by Roger McNamee and John Powell in the 1990s. Another hedge fund to have dipped their toe into tech investing is Tiger Global, which created a separate venture fund that has, to date, backed tech startups such as Eventbrite, Pure Storage, Warby Parker, and Redfin.

Snapchat was just one in a sequence of mid-stage private tech investments by Coatue, who established a $300m growth fund for this very purpose last year. Another recent investment by the firm was in leading mobile travel startup Hotel Tonight’s $45 million round last September, and it also participated in Box’s 2012 funding round.

Other major hedge funds to have crossed over into backing private tech firms include Altimeter, which has been doing so for the past few years, and Valiant Capital Partners, which has invested in Dropbox, Pinterest, and Evernote over the past couple of years. While most hedge fund tech investments come at the growth stage, some have engaged in seed-round investing, including Maverick Capital, which made seed investments in Zenefits and beacon developer Estimote in 2013.

What’s in it for hedge funds and entrepreneurs?

Startup-Domination-Map- Hedge Funds Increasingly Investing in Tech Startups

Instagram was bought for a reported $1 billion by Facebook – representing a huge profit for its early stage investors

It’s easy to see the appeal of tech investment for hedge funds, as although they can be risky, the potential returns can be huge – witness Facebook’s $1 billion purchase of Instagram for a case in point. While many funds went off the idea after the bursting of the dot-com bubble in 2000, the pendulum seems to have swung back in favour of the practice. One of the main reasons for this is that tech companies are, on the whole, waiting longer to go public. In the past, it was commonplace for tech companies to wait for a $100 million revenue run rate before they would go public to fund international expansion.

Now, it seems the trend is for companies to hit this revenue and experience international growth before they go public. The most high profile cases of this in recent times have been Facebook and Twitter, both of which were huge international names before they issued IPOs. Another benefit of going public, namely employee liquidity, is something that can also be accomplished with private funding, with companies such as Twitter doing this before their IPOs.

The problem with this model, from a hedge fund point of view, is that if a company has reached a certain stage of maturity by the time of their IPO, the potential upside for investors is greatly reduced. We have seen this with Facebook, which slumped dramatically before eventually recovering to slightly above the IPO price, and Twitter, which has just slumped amid speculation that the Twitter craze may be winding down. However, the VCs that invested in these companies at an earlier stage made huge profits, which is why hedge funds are looking to enter the picture earlier.

One of the benefits of engaging in both public and private investing for tech-focused hedge funds is that the expertise gained in one market can be leveraged for the other. For example, a knowledge of mobile advertising trends gained in the private sphere can be useful in evaluating the prospects of listed tech stocks that use this as a revenue stream. This is also true of crossover funds focused on other sectors, with Altimeter Capital’s investments in private and public travel companies being a prime example.

One powerful indicator of this trend has been the number of hedge fund investors turning up to investment-backed private tech gatherings such as the Goldman Sachs Private Internet Company conferences over the last couple of years. Back in 2008 and 2009, it was rare to see any hedge fund people at these events, whereas in the last two years they have been packed out with hedge fund managers.

From the point of view of early stage entrepreneurs, especially those at the growth funding stage, extra capital is always welcome, no matter where it comes from. Although hedge funds don’t give the same support as VCs, they are often prepared to give higher valuations to the founders than VCs would be prepared to.

Hedge funds can afford to be a lot more flexible on pricing, because they aren’t obliged to return money in the same way that VCs are. VCs aim for a much higher return, whereas hedge funds would be delighted with just 10 to 20 percent – well above last year’s average hedge fund return of 7.4 percent. Because they are more flexible, hedge funds can get the cash a lot quicker to the founders, unlike VCs which operate on a commitment basis and don’t put up the whole amount at once. Basically, hedge funds are a more ready source of quick, easy cash than VCs – and this is central to their appeal to capital-hungry startups.

Suitable for every situation?

Startup-Domination-Map- Hedge Funds Increasingly Investing in Tech Startups

Snapchat obtained $50m in growth funding from hedge fund firm Coatue Management

Going the route of taking entire rounds from hedge funds, as was the case with Snapchat, isn’t appropriate to every situation. Hedge fund investors tend to be passive investors, are highly unlikely to get involved in board-level decisions or operations in the same way a VC might. VCs add a tremendous amount of value to the startups they back, and without them, a founder might lack sufficient guidance, connections, and business clout to achieve their objectives.

This need not be an issue if there are already a few high-profile VCs on board, and in the case of Snapchat, they had already taken money from several big name VCs such as Lightspeed, Benchmark Capital, and General Catalyst.

Another potential pitfall to taking the hedge fund route is that they tend not to hang on to stock for too long, and are much more likely to dump their considerable holdings shortly after the company goes public – sending the share price into freefall. They have also been known to sell off private stock whenever a company encounters problems such as falling user numbers, which could leave a startup with investors they have no prior knowledge of. In most cases, VCs will be prepared to ride out storms and play the long game, but this is not necessarily true of hedge funds.

The trend of hedge funds getting into private-company investing at the early stage is symptomatic of a growing divide between company-building, which VCs are better at, from capital, which hedge funds provide easier access to.

The increasing presence of passive investors in tech firms may also be a symptom of what many perceive to be a rapidly-inflating tech bubble in an echo of the late 1990s situation. The more hedge funds get involved in early-stage tech firms, the more that valuations will be driven up, giving rise to a bubble. However, today’s hedge fund tech investors are more savvy than their 1990s counterparts, and for the most part seem to be doing more in the way of due diligence and convincing entrepreneurs that they are adding value to the businesses they invest in.