Friday, February 09, 2007

Red Herring On Pay By Touch & Hedge Funds






Hedge Funds Take On VCs


Armed with piles of cash, hedge-fund investors are elbowing in on venture capitalists to get a piece of the early-stage investing pie.
By Sunshine Mugrabi
Ask Gus Spanos, CFO of biometrics company Pay By Touch, about how his company was financed, and you might feel like you’re dealing with an evangelist. He believes technology companies should have choices when it comes to assembling an investment team—and venture capitalists just aren’t making his list anymore.

His company was one of the first to go to the newest financial big kids on the block: hedge funds.

Now, the trend is picking up steam, as more startups discover a new pool of capital waiting in the wings.

“Hedge funds have expanded the number of options for financings for young and growth companies,” says Mr. Spanos.

Once largely the province of venture capitalists, technology financing deals are now attracting a host of new investors, chief among them hedge funds. While hedge funds typically are interested in investing at the pre-IPO, or “mezzanine” stages, they are increasingly getting involved at earlier stages. For example, San Francisco-based hedge fund Artis Capital Management was an early investor in web sensation YouTube.

The hedge fund industry has become intensely bloated over the past 15 years, with assets growing from $39 million worldwide in 1990 to $1.3 trillion today. That money has to go somewhere. In the past, hedge funds invested in publicly held companies—most classically taking long and short positions in order to “hedge” their investments. Now, these funds are chasing returns wherever they can be found.

Mixed Welcome

For entrepreneurs chafing against the traditional venture model of high equity stakes and board control, hedge funds are welcome newcomers. Quite often, hedge fund capital arrives more quickly and with seemingly fewer strings attached. But VCs, already pressured by lower returns over the last few lean years, are hardly happy about the competition. They claim hedge funds have changed the rules of the game to the point that their gains can be at the expense of co-investors. They also say the type of financial engineering hedge funds employ can put entrepreneurs at risk.

Pay By Touch, based in San Francisco, sells a fingerprint-based payment system now used in 42 states. In 2004, the company set out to raise $30 million to $40 million in a second round of funding, having been funded in a first round by private investors.

The company was cash-flow negative, but its intellectual property was valuable, claims Mr. Spanos. And Pay By Touch had a strong management team and board of directors, including John Morris, a veteran of IBM, and John Costello, a former executive vice president at Yahoo and a top executive at Home Depot.

Backed by private investors like billionaire Ron Burkle of supermarket buyout fame, they figured they would have no trouble attracting venture financing.

VCs did come knocking. The problem, says Mr. Spanos, was that they demanded big stakes, board seats, and wanted significant control over the company—in short, standard VC stuff. That’s when hedge funds crashed the party.

In September 2005, the company closed a financing round totaling $130 million, of which $75 million was brokered by Swiss giant UBS. The financing was led by Och-Ziff Capital Management of New York City, and included two other hedge funds, Farallon Capital Management of San Francisco and Plainfield Asset Management of Greenwich, Connecticut. Between them, Och-Ziff and Farallon control over $25 billion worth of capital.

At Mr. Spanos’ request and that of Pay By Touch CEO and founder John Rogers, the financing from the hedge funds was in the form of a senior secured note. The primary collateral was the company’s intellectual property, which included over 50 patents.

The hedge funds received less than 10 percent equity, as opposed to the 20 percent or more VC firms had demanded, and no board seats. Pay By Touch raised the other $55 million in convertible promissory notes—another debt instrument—from individuals, family foundations, and smaller institutions. These notes were eventually converted into the company’s third financing round.

John Rogers, founder, CEO, and chairman of Pay By Touch, later publicly praised Mr. Spanos as a “rainmaker” for his skill in putting together such a unique financing deal.

Pay By Touch has since raised an additional $150 million from hedge funds and private investors. And though it was one of the first privately held technology companies to tap hedge funding, it is not alone. In the last two years, at least 27 private technology companies at various stages of growth have gotten hedge fund backing in the United States.

Kathryn Coffey, partner at Seven Hills, a San Francisco-based financial advisory firm, says hedge funds operate in a number of ways that differ from the traditional VC model. For example, they often pass on board seats—preferring to leave such detail and control to the management team and the VCs.

Culture Clash

That’s just one of many differences startups are beginning to appreciate, says Ms. Coffey, who has brokered several deals involving both hedge and VC funds. Another is that hedge funds tend to have lower expectations about returns.

They look for solid performers, preferring not to depend on the home-run plays VCs need to remain profitable. VCs often expect 60 percent invested rate of return (IRR), while hedge funds might expect as little as 20 to 25 percent IRR.

“A hedge fund is willing to take a lower return because it’s putting a lot more money to work in safer deals,” says Bob Machlin, CEO of SkyPilot Networks, a Santa Clara, California-based telecom startup that was recently backed by hedge fund Palo Alto Investors.

The time it takes for a hedge fund to put together a financing deal is also refreshing to many entrepreneurs—averaging about six weeks, as opposed to up to six months of due diligence in the venture world. And many entrepreneurs say they find a hedge fund’s connections on Wall Street helpful in smoothing their transition from private to public entities.

Hedge funds don’t necessarily have to cash out when a company goes public, while VC firms often have to in order to fulfill their obligations to limited partners.

“There’s no set thing we do,” says Dr. A. Joon Yun, partner and healthcare analyst at Palo Alto Investors, a hedge fund with about $1.2 billion under management. “If a company goes public at a high price relative to its value, we’ll be selling,” he says. “If it’s a low price, we’ll be buying.”

Hedge funds often have a different agenda than VC firms going into a deal, says Ned Scheetz, a partner at Aphelion Capital, a San Francisco-based healthcare technology investment firm that, while not technically a hedge fund, makes investments on both the public and private equity sides. For example, they might invest in one company simply to determine their investment strategy for an entire industry.

For a company like Pay By Touch, hedge funds were apparently a good fit. But even Mr. Spanos acknowledges that the deal he cut isn’t for every entrepreneur. Venture capitalists offer a lot to younger technology companies, which benefit from their guidance and expertise. And without the key collateral his company had to offer, he doesn’t believe he could have requested such favorable terms.

1993-2006 Red Herring, Inc. All rights reserved.

About Gus Spanos

Prior to joining Pay By Touch, Gus Spanos was a partner with JH Partners, a private equity firm for which he helped raise their inaugural $200 million institutional fund. Some of JH Partners' portfolio companies included Peet's Coffee & Tea (NASD: PEET), Design Within Reach (NASD: DWRI) and Bare Essentials / MD Beauty. Spanos has led the acquisitions of approximately 30 companies over the past 16 years. His investment experience began in 1989 as President of a private equity firm that he co-founded, which was affiliated with Gryphon Investors, Inc. from 1996 to 1997. Prior to that, Spanos worked as an investment banker in corporate finance and mergers and acquisitions with Goldman Sachs and Co. in New York. He has eight years of operations experience in executive positions as President, EVP or CFO of private equity-backed companies. He received an A.B. from Harvard College and an MBA from The Stanford Graduate School of Business.

Pay By Touch

My photo
Scottsdale, Arizona, United States