Hungry for More
October 01, 2007 - Venture Capital Journal
By Joanna Glasner and Alexander Haislip
Hedge funds have taken a bite out of venture deals and they're eyeing their next meal.
Venture capitalists have always been fond of business models that disrupt other people’s industries. When it comes to their own turf, however, a new breed of rivals is bringing the threat of such havoc uncomfortably close to home.
Big hedge funds—those lightly regulated and enormously deep-pocketed investment vehicles for the affluent—are increasingly moving into venture. And with them, they’re bringing the vast cash reserves, quantitative know-how and swift deal-closing ability that have made them a force to be reckoned with on Wall Street.
While the number of hedge funds investing in venture is still quite small, they are showing up in deals with more frequency, raising the hackles of longtime VCs. Asked why he thinks so many hedge funds have jumped onto his turf, Joe Schoendorf, who has been with Accel Partners for nearly 20 years, snips: “Greed and ignorance. We have seen this movie before.”
It’s too early to say if hedge funds are in venture for the long haul or if it’s just a fleeting fancy. What is clear, however, is that they are the furthest thing from dumb money. VCs that have invested alongside them report that they are thorough in their due diligence, hyper-aware of the competition and adept in arranging complex financings such as roll-ups or prepping companies for public offerings.
What’s bringing these sharks into the sheltered harbor of Silicon Valley startups? Erik Straser, a partner at Mohr Davidow Ventures, says it is all about valuations and allocations. The hedge fund investors are looking for private companies that will likely go public within two years. “They want to get in early at this cost of capital and not fight for an allocation later on,” he says.
Bill Burnham, a former Mobius Venture Capital investor and founder of small hedge fund Inductive Capital, says hedge funds are moving into venture in an effort to diversify into privately held assets. “There’s a broad movement among a number of larger funds to build more of an active management business,” he says. “They have lots of capital to put to work, so it just makes sense to expand into different asset classes.”
This year, hedge funds have allocated more than $1.5 billion to dedicated venture investment funds, according to VCJ research. Venture investment across the hedge fund industry is higher, however, as most funds haven’t broken out how much they’re allocating to the sector.
Judging by the first three quarters of 2007, hedge funds are on track to invest in venture rounds valued at more than $1 billion this year. Leaders in the space include Alliance Bernstein, a $742 billion asset manager that launched its venture arm this year and has already backed 10 companies, and D.E. Shaw Group, a $37 billion hedge fund operator that has made about a dozen venture capital investments and recently expanded its Silicon Valley investment team.
Other players include Och-Ziff, the $27 billion New York-based hedge fund that recently filed to go public and has been aggressively investing in venture capital and buyout deals over the past two years, The Galleon Group, a $5 billion New York-based hedge fund focused on information technology stocks, which recently closed a $300 million venture capital fund that will focus on late stage investments, and Tudor Capital, a $15 billion hedge fund that has invested in three startups since the beginning of July.
Today, hedge fund investments in venture still represent only a pittance of their total holdings. Should hedge investors take an active interest in private equity, their funding capacity would dwarf the existing venture industry. Today, there are approximately 9,000 active hedge funds that comprise a $1.1 trillion industry, according to the Hedge Fund Association, a trade group. Venture capital firms, by contrast, invested just over $26 billion in all of 2006, and $14.5 billion in the first half of this year.
Friend or foe?
For venture investors, the question of whether hedge funds represent friend or foe varies with investment strategy. VCs in early rounds who have later partnered with big funds tend to put them in the ally camp. With companies waiting longer to tap the IPO market, hedge funds can provide valuable interim financing, especially in life sciences, says Farah Champsi, a managing director at Alta Partners.
In late rounds, hedge funds pose the most formidable competition for established venture funds, Burnham says, in part because they have a culture of making decisions quickly. Growth-stage venture funds such as Technology Crossover Ventures, which declined to comment for this article, would seem to be in the most worrisome position because they are vying for the same sorts of late stage deals that hedge funds are targeting.
To compete, venture growth investors facing off against big asset managers have drawn upon their operational experience to win oversubscribed rounds. That was the case for New Enterprise Associates general partner Krishna “Kittu” Kolluri, who led a $100 million September growth round in OANDA, a profitable operator of an online currency trading platform. Kolluri says his firm was up against several large institutional asset managers. His strategy was to convince company executives that NEA was better equipped to help them scale than competitors. “They’re financial experts, not company builders,” says Kolluri, a former serial entrepreneur.
Such rivalry between VC and hedge investors is more likely to show up at Series D than Series A. At the early stage, hedge funds aren’t as big a threat, primarily because they lack the human capital to go after that business, says Burnham. But even early stage investors occasionally find themselves competing against a hedge fund. Looking at prior financings, there’s no standard venture deal for these investors.
And hedge funds are steadfastly sector-agnostic, too, pursuing deals in everything from biofuels to cancer drugs to pre-paid phone cards:
• Stark Investments led a $21 million second round of funding in September for Virent Energy Systems, a Madison, Wisconsin developer of processes for producing renewable fuels.
• Duquesne Capital Management led a $41.3 million Series D round in July for Agensys, a Santa Monica, Calif.-based developer of antibodies for treating cancerous tumors.
• And Plainfield Asset Management and parent company The Cisneros Group led a $40 million round in August for Movida Communications, which markets prepaid mobile phone services to Latino communities.
They could pass for VCs
Massive capital reserves aside, hedge funds are making efforts to blend in to the venture scene, both leading rounds and co-investing in VC-led deals. While best known as finance gurus, they’re also hiring scientists, techies and other dealmakers who seem very much like the venture capitalist next door.
Certainly D.E. Shaw’s Alex Wong fits that description. Before joining Shaw, Wong made venture investments in the semiconductor industry for Apax Partners and Intel Capital. He has an engineering Ph.D. and is also attempting to wean himself from an addiction to Silicon Valley electronics superstore Fry’s.
“I never looked at them as a hedge fund,” Raymond Johnson, CEO of Infinite Power Solutions, says of Shaw. “They always acted like, presented like, and talked like a VC.”
When raising an expansion round last year to fund a manufacturing facility to produce its tiny batteries for microelectronic devices, Infinite Power initially focused on venture investors. Johnson ended up picking Shaw to lead the oversubscribed $38 million round largely because of Wong’s expertise in building fabs.
Says Johnson: “My initial feeling was that hedge funds send you money, ask for a quarterly report, and you may never hear from them again. This is not that at all. This is very hands on.” He points to a recent hire of a hard-to-fill vice president of manufacturing position. Wong introduced several candidates and eventually referred Johnson to the recruiting firm that found the new VP.
It’s not uncommon to find hedge funds with deep industry expertise, says Paul Kanan, CFO at cancer drug maker Agensys, who approached several hedge investors while raising an expansion round earlier this year. “There were some we met who were purely financial people, but we met a lot of technically skilled people out there, too,” he says.
Agensys eventually settled on Duquesne, a Pittsburgh-based hedge fund to co-lead its $41 million Series D round in July. In addition to the money, Agensys added a strategic advisor to its board: Duquesne managing director Kenan Turnacioglu, a Ph.D. cell biologist who Kanan says also manages a $500 million portfolio of life sciences investments in the public markets.
Hedge funds are also doing their diligence. Susan Mason, a general partner at Onset Ventures, says she was impressed by the hands-on approach of co-investors at Alliance Bernstein, who participated in a recent $27 million round for mobile phone payment service Obopay. To get into the oversubscribed round, Mason recalls, the Alliance team put together a detailed analysis booklet on what they thought Obopay could be and how they could add value.
“They were very involved for a late stage investor,” she says. “I’m used to the later stage guys doing very little work in helping the company make introductions or build out their Rolodex.”
Hedge funds are also making an impression around the negotiating table. When it came time for thin film solar cell developer Nanosolar to raise another round last year, Mohr Davidow’s Straser recalls that some of the smartest people at the table had come from hedge funds. “These weren’t just randoms,” he says, “They were people who had made money in these industries already. They were hunting. We weren’t selling them on this market; they were already there.”
The proof was in the array of investments they had already made in the industry. Straser says he had been tracking the biggest shareholders of publicly traded solar companies for some time. When SAC Capital Advisors and GLG Partners, hedge funds of roughly $12 billion each, approached Nanosolar, Straser knew they were deeply involved in solar. The two hedge funds joined with Swiss Re, Grazia Equity, Christian Reitberger, Jeff Skoll’s Capricorn Management and others in Nanosolar’s $75 million Series C in June 2006.
Fast rounds, high valuations
As hedge funds become more active in venture, entrepreneurs are turning to them for funding along with or possibly in lieu of venture firms. In raising its latest round, Agensys, for example, made a determined effort from the start to target hedge funds, though Kanan says he also talked to VCs and venture growth funds. In the end, Duquesne’s speediness in agreeing to terms gave it an edge in securing a lead spot in an oversubscribed round that also included Alta Partners and half-dozen other venture and private equity investors..
Kanan was pleasantly astounded by the rapidity with which Duquesne was able to close the latest round. From start to finish, the round took less than four months, with barely a hiccup in the negotiation process. “In my 20 years of fund-raising,” Kanan says. “I’ve never experienced a financing that went that smoothly.”
Hedge funds have also been known to push up valuations. In late-stage rounds, they “tend to be less valuation-sensitive than venture funds,” says Alta’s Champsi, also an Agensys board member. That propensity came across during fund-raising, says Kanan, who observed that venture capitalists “seem to spend a lot more time on valuation than the hedge funds do.”
The presence of more large asset managers—be they hedge funds or other institutional investors—in growth rounds is playing a role in raising deal size, too. In putting together September’s OANDA round, for example, NEA’s Kolluri says competing asset managers pushed up the valuation to the high end of his expected range. Investor demand was sufficient to push the price even higher, he said, but executives kept the round down somewhat by focusing on a few favored backers.
Today, overall hedge fund investment levels are too low to put pressure on venture valuations except in isolated cases. Even so, the size of follow-on rounds is still on the rise. Among San Francisco Bay Area companies that raised follow-on rounds in the first half of the year, valuations rose by an average of 75%, according to a survey by law firm Fenwick & West. The increase was the highest in the survey’s five-year history.
For entrepreneurs, the most obvious appeal of a hedge fund is its ability to invest vast sums of money. With billions at their disposal, hedge funds are capable of providing startups with capital to vie off competitors and even, in some cases, to buy them out.
Granted, top-tier VCs can mostly match those offerings. But for private companies in sought-after funding rounds, hedge funds can offer a compelling sales pitch. Beyond vast capital, their strengths include a flexible investment timetable, connections to powerful publicly traded companies and experience in complex financings.
The latter appealed to Pay By Touch, a developer of biometric-based payment systems. When the San Francisco company needed to raise money two years ago, it turned away traditional venture capital and looked toward hedge funds. The company had previously raised $50 million in two rounds from investors including Mobius Venture Capital and the Gordon P. Getty Family Trust. It wanted more money to continue acquiring key patents and to accelerate its expansion.
Founder John Rogers didn’t want to lose control by selling more of the company’s equity. So for its next round of financing, the firm took out a $75 million loan. Och-Ziff led the financing with help from Farallon Capital Management and Plainfield Asset Management.
Pay By Touch also raised $55 million in convertible promissory notes—which could be turned into shares when the company prices its third round of financing. The Och Ziff-led round included the purchase of Mobius Partners’ stake in the company, for a 1.75X return, says Burnham, a former Mobius managing director.
To date, Pay By Touch has raised well over $200 million in debt and equity financing. Since the infusion from Och-Ziff, the company has made at least five acquisitions of companies in the payment processing, biometrics and loyalty marketing industries
Rollups aren’t beyond the capabilities of venture capital firms. VCs have occasionally spearheaded such transactions, as in last year’s acquisition by venture-backed Cortina Semiconductor of a complementary Intel division. But it’s not their bread and butter.
To the extent hedge funds are picking the kinds of private finance transactions that most VCs shy away from, they’re not a big threat to venture firms, says Tom Simpson, managing partner of Northwest Venture Associates. However, he adds: “If they’re just coming in to support the next Series A for the next Web 2.0 company, then it’s just a game of musical chairs, because there’s ample capital available for those sorts of investments.”
Certainly there’s ample capital for promising startups in other sectors too, particularly solar. Robert Ford, CEO of silicon solar panel maker Solaicx, says he had multiple venture suitors, but he considered the deep pockets associated with a big hedge fund investor in selecting D.E. Shaw as a backer. The 5-year-old Santa Clara, Calif.-based company closed a $27 million Series C round in April to fund a manufacturing operation in Portland. Ford says he went with Shaw both for its financial resources and for the operational expertise of Wong, who invested in solar cell manufacturer Q-Cells when he was Apax. “We saw them as tier-one VCs who had the additional capability of added financing downstream,” Ford says.
For Portola Pharmaceuticals, which develops treatments for cardiovascular diseases, the participation of Alliance Bernstein and Brookside Capital in its May expansion round had a strategic benefit, says Alta’s Champsi, a Portola board member.. Brookside’s team helped Portola partner with a large pharmaceutical company Brookside had strong connections to.
It’s too early to say if hedge funds make great VCs. So far, their investments have generated few exits. For the most part, those that have matured to exit have not generated the “home run” multiples VCs covet.
But hedge investors tend to have more modest ROI expectations than VCs, says Alta’s Champsi. In her experience, hedge investors have focused on selecting private companies close to exit rather than chasing 10X multiples.
“Because they have a sense of what the public markets are like, they have a good sense of when a company could potentially access that,” she says. And when a company does file for an IPO, “They could provide some credibility to the street as a quality buy-side fund that is already committed to the company.”.
When hedge funds have made money on venture deals, they’ve often done so quickly. Och-Ziff, for example, invested in a $21 million expansion round for NewStar Financial, a provider of debt financing services, in March 2006 at a valuation of $190 million. The company went public in December and currently trades around $11, with a market cap around $400 million. Och-Ziff had 4.8 million shares at the time of the offering.
Palo Alto Investors and Och-Ziff also profited from their investments in Amicus Therapeutics, which they made in 2005 at a valuation of $83 million and in 2006 at a valuation of $184 million. Amicus, a developer of treatments for genetic disorders, went public in late May and is currently valued around $280 million.
Other deals in registration promise similarly fast returns. MAP Pharmaceuticals, which makes inhaled drug products, raised $50 million in a March round that included D.E. Shaw and seven other investors. Three months later, it filed for an IPO.
Stark Investments, meanwhile, is listed as a 2.4% stakeholder in Imperium Renewables, a biofuel company that filed to go public in May.
Stark also bought small stakes in two venture-backed Wisconsin companies that have gone on to exit this year, according to Scott Button, a managing director at Madison, Wis.-based Venture Investors, an early stage backer in those deals. One was TomoTherapy, a developer of cancer radiation treatment systems that went public in May, and the other was NimbleGen, a gene chip maker acquired by Roche in June.
As hedge funds build up a track record in venture, they’re also building up an impressive deal pipeline. For example, Stark has invested in four of Venture Investors’ portfolio companies, and Button expects the relationship to continue. Stark is handy because it’s nearby in an area that isn’t rife with venture funds and it has expertise in key sectors of interest to Venture Investors, such as energy.
“From having done a number of prior deals, we see that they think and act very much like a venture fund,” Button says. “That’s one of the reasons we’re comfortable.”
Entrepreneurs are also taking the hedge fund route, bypassing VCs altogether. Ashfaq Munshi, founder of online real estate resource Terabitz, is a case in point. Munshi says he turned to Tudor Capital for a $10 million Series A investment in July because it was able to move fast, offer funding for rapid acquisition and consolidation, and provide connections to critical corporations. The serial entrepreneur says he didn’t even approach venture capitalists to fund the round.
“If you think there’s a sector that is very interesting and might be consolidated, that’s not a conversation you can have with VCs,” Munshi says. “They think it means you’re taking the eye off the ball instead of getting the ball to be bigger and come faster.”