Monday, November 20, 2006

Hedge Funds Move Into VC Turf

Tech startups take capital where they can get it. Hedge funds are getting in.

November 17, 2006 Red Herring Magazine

When news hit last month that hedge fund Artis Capital Management was an investor in web sensation YouTube, it shed a light on what is becoming an increasingly common practice.

High technology startups are turning to hedge funds for financing, particularly when they reach the later stages and need the capital to prepare for an initial public offering. Yet, as hedge funds begin moving into investment areas that were once the exclusive realm of venture capital firms, the old way of doing things is being disrupted.

“As (hedge) funds get larger, they are looking for new places to invest,” said Kathryn E. Coffey, partner at Seven Hills, a San Francisco financial advisory firm.

With the cost of doing an initial public offering skyrocketing in light of new regulations and the current investment climate, startups need significantly more capital to jump these hurdles than they did five or six years ago. Hedge funds, said Ms. Coffey, often have access to public markets that can help smooth the transition from private to public.

“A number of companies are talking to hedge fund groups,” said John Balen, general partner of Canaan Ventures, a Sand Hill Road venture firm.

Sometimes companies avoid dealing with venture capital altogether. Pay by Touch, a San Francisco biometrics company that has developed a fingerprint payment system, raised two rounds totaling $190 million in October 2005 and January 2006 from hedge funds Plainfield Asset Management and Scout Capital, plus private investors such as Quince Associates and Global Trust Partners, among others.

Industry observers say the biggest tension between the two types of firms is in their expectations about how much they will earn from their investments. Because hedge funds are highly diversified, they usually don’t have the same need for high returns from individual companies in which they invest. In contrast, venture firms have often been with a company through several stages and are counting on big returns at the end.

The difference can be between an expectation of 60 percent returns on the part of a venture firm, and a mere 23 percent for the hedge funds, said Eric W. Edmondson, partner at Seven Hills. This means that the team of investors shepherding a company toward going public or being acquired can have very different ideas about strategy.

Hedge funds usually involve themselves in later stage deals and are rarely interested in getting in on the ground floor of a new business. (Artis’s investment in YouTube is an exception to this.) Ms. Coffey said that in her experience, they’re seeking companies with a solid management team in place and a track record of performance that can be extrapolated into the future.

Not Hands-on

They also usually choose to remain in the background, she said. They don’t take seats on boards of directors as venture and private equity firms often do, and they usually aren’t all that interested in the hands-on running of the business.

Some in the technology finance world say it’s inevitable that hedge funds and venture capitalists are going to find themselves doing deals in the same space. Some even go so far as to say the traditional venture model is irreparably broken and that a new model is being constructed on the ashes of the old. Hedge funds, in this scenario, are merely taking advantage of an opening.

Clearly, certain factors that fueled the last technology boom have shifted. Nowadays, limited partners—the entities who fuel all of the private equity that invests in technology—have quite a lot of capital to invest in areas that used to be considered too risky for them, such as high technology startups. At the same time, multibillion-dollar IPOs and other profitable exits are becoming rarer.

Capitalism: Broken?

Drew Lanza, general partner at Morgenthaler Ventures, a Sand Hill Road venture firm with offices across the U.S., says the old way of doing things—expecting a big, splashy IPO at the end of the tunnel—is just not happening anymore.

“Capitalism is broken. We broke it,” he said. Luckily, he added, this has happened several times in the past and it’s always been repaired one way or another.

And while congress debates whether to regulate the hedge fund industry, for now at least these types of funds have free range to do a wide variety of deals.

As Mr. Lanza sees it, “Any time there is a movement, opportunity is created.”

The question remains, however, who will benefit from all this opportunity, and who will be left behind.
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