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Hedge Funds and Startups (Giacomo Bottoli)

A startup is almost impossible to start and scale up without money; this is why entrepreneurs always look for external investments to sustain their journeys. The most common ways to raise capital are bootstrapping (receiving funds from family and relatives), business angels and VCs. This article will explore an alternative and much less popular method of raising capital, which has the potential to inject remarkable amounts of capital into this industry: hedge funds.

 

Ideas are useless! Yes … if entrepreneurs do not have access to the capital required to translate ideas into reality, those ideas are useless. Indeed, a startup is almost impossible to start and eventually scale up without money; this is why entrepreneurs always look for external investments to sustain their journeys. Without capital, a startup does not survive. According to CB Insights’ “top 20 reasons start-ups fail” ranking, close to 30% of failures in the startup industry are due to lack of cash.

The most common ways to raise capital are bootstrapping (receiving funds from family and relatives), business angels and VCs.

Venture Capital, in particular, is perceived as the major lever on which startups can count when in need of fresh capital to scale up; the sector has grown by 12.1% annually since the financial crisis in 2008, and the amount of capital raised per year has grown by 100% over the decade. As can be seen in Table1, 2018 has been a year of superlatives for the VC industry: the most amount of money invested in the highest number of private tech company financing events on record; the largest venture capital deals in history; and the rise and rise of supergiant venture rounds (Jason D. Rowley, 2019).

VC Rounds This article will explore an alternative and much less popular method of raising capital, which has the potential to inject remarkable amounts of capital into this industry: hedge funds. Often overlooked by entrepreneurs, it has been demonstrated in the recent past (2014-2015) that hedge funds are able to actively sustain innovation and support the startup industry. Despite the fact that in the last 3 years the number of startups backed by hedge funds has decreased, some funds have recently started building entrepreneurial in-house hubs dedicated to welcoming and hosting promising startups backed by the group. Are hedge funds planning to redesign their investment structure and direct more resources to private equity?

 

A hedge fund is an offshore investment fund, typically formed as a private limited partnership, that engages in speculation using credit or borrowed capital (leverage). The first hedge fund in history was created by former writer and sociologist Alfred Winslow Jones in 1949. Since then, hedge funds have gone on to dramatically outperform most mutual funds (in the 1960s) and gained further popularity when a 1966 article in Fortune highlighted “an obscure investment that outperformed every mutual fund on the market by double-digit figures over the previous year and by high double-digits over the previous five years” (James Chen, 2019).

Hedge funds’ interest in the startup industry became clear in 2014 when hedge fund Coatue Management participated in Snapchat’s $50 million round of funding; according to Matthew Wong, data analyst and researcher for CB Insights, hedge funds’ investments in startups were triggered by the rise of the fintech sector after the financial crisis in 2008; the implementation of new technologies in the financial world generated an enormous flow of money poured into Silicon Valley from hedge funds. Initially, investments were focused on marketplace lending and progressively this money started moving into other fintech areas like insurance and management systems for small businesses.

“There was a huge wave in 2013” of hedge funds and other alternative investment firms shifting into the fintech space, recalls Fiona Grandi, a financial services fintech leader at KPMG.

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 the last decade. One of the pioneers of this approach was Integral Capital Partners, which was founded by Roger McNamee and John Powell in the 1990s.

Between 2011 and 2014 (as shown in Table2), Tiger Global Management was the hedge fund that invested the most in the startup industry:

Table 2 (Tiger Global Management Private Equity investments' presence)


Graph 2

Here is a list of hedge funds’ funding activities in the private equity sector during recent years:

  • Hedge fund Tiger Global invested through a separate venture fund in Warby Parker, Nextdoor, Redfin, Eventbrite and Pure Storage, Nubank (a digital finance company in Brazil) among many others
  • Valiant Capital Partners has backed Dropbox, Evernote, and Pinterest in the past
  • Maverick Capital ($10.5 billion hedge fund) has participated in a few seed deals, including Zenefits in 2013. The fund isn’t just going after growth-stage funding; in December 2013, the firm participated in a seed round in Estimote, which develops beacons. The firm also backed Vserv, a digital platform for mobile marketing and commerce in India and Southeast Asia that has raised more than $10 million
  • Steadview Capital invested $200 million in India in 2015, investing in start-ups such as Unacademy, Ninjakart, and Dream11
  • Falcon Edge Capital has backed start-ups such as Stanza Living, WickedRide, Mswipe, Locus and Credit Vidya, helping these companies raise around $220 million with other investors
  • Passport Capital, the $4.4 billion hedge fund run by John Burbank, has made a dozen investments in United States tech start-ups, according to the research firm CB Insights. Passport’s fintech investments include CashStar, the maker of prepaid cards for retailers and restaurants, and Prosper, the online marketplace lender.

 

During 2013-15, hedge funds were certainly seeing the potential for greater returns by entering the private markets. This was due to the fact that tech companies were waiting longer to go public. “It used to be that the benchmark to go public was a $100 million revenue run rate, and the strategy would be to go public and then use that money to expand to international markets” (Leena Rao, 2014).

However, during those years, companies were generating this revenue and expanding internationally in the private markets. Twitter and Facebook both had this type of growth before their respective IPOs. By the time hedge funds started investing in these companies on the markets once they were public, there was not much upside in a two-to-three-year time frame. So, to achieve some of the upside that VCs were seeing with hits like Twitter, Facebook and others, hedge funds were starting to go upstream in the investment stage.

For early-stage entrepreneurs, especially those looking for Series B/C and growth funding, hedge funds represented the best option possible to raise capital for the time. Hedge funds in fact, could afford to be flexible on pricing, and tended to give founders higher valuations. Many hedge funds were willing to give founders valuations that VCs would have never been willing to accept.

Because hedge funds are often flexible in their mandates, they have the capacity and permission from their LPs to fund private deals. Indeed, they can be flexible on pricing and valuations, because a 10% or 20% return is stellar (in 2013, hedge funds returned an average of 7.4%). On the other hand, VCs usually tend to aim toward a much higher percent return — and need to price and value startups to optimize for that. And because of this flexible structure, hedge funds are still nowadays able to give founders cash more quickly than a VC. Hedge funds have their cash on hand and can liquidate faster. VCs operate on a commitment basis and don’t collect their entire funds at once.

Snipped imageToday’s situation is quite different. Hedge funds’ investments in the startup industry have drastically decreased and VCs have taken the lead when it comes to backing promising startups. Despite this, some hedge funds have started creating and launching programmes focused on hosting and supporting startups. Indeed, given the past episodes, higher profitability in investing in startups (IPOs are hitting all-time high valuations) and the growing number of unicorns around the world, hedge funds are getting attracted by the private equity sector again in hope of generating massive profits on investments. The recent period of bullish markets (the U.S. in particular, excluding 2018) allowed hedge funds to produce high returns from the financial markets. However, given the inversion of the 10 years US yield curve and geopolitical risks, analysts suggest that we are close to a recession and markets’ investments might not be able to generate stellar returns anymore; this is why a strong return of hedge funds in the private equity is likely to happen within the next 3-5 years. As represented in Figure1, hedge funds such D.E. Shaw are recruiting experienced entrepreneurs and have started creating in-house innovation hubs to welcome and support promising startups. Not to forget, compared to previous years, hedge funds will have access to a much wider variety of sectors to invest in, given the growing numbers of entrepreneurial ventures globally. This time, in fact, hedge funds will not just focus on fintech, but will actually expand their horizons and sustain innovation at 360° in diversified business sectors (Big Data, AI, IoT). AI algorithms and Big Data specifically are the sectors in which hedge funds are expected to allocate more capital, since by backing potential breakthrough discoveries in these fields, hedge funds would be able to generate above-average returns and acquire a competitive advantage in the long run. The relationship between hedge funds and startups is far from over, and in the next few years we are likely to witness some surprising funding transactions.

 

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Doing Digital Innovation & Entrepreneurship at Warwick, I have been exploring how start-ups and new technologies are changing the world and the role these ventures cover in our society. I am very passionate about it. I am a second-year student involved in many societies (Warwick Finance Society, Warwick Trading Society, Warwick Incubator). I am very interested in financial markets. During my first year I completed a spring internship working as private consultant for start-ups in London and participated at the Start-up Internship Immersion Programme (GBA International Institute for Innovation) in Hong Kong and Shenzhen. I like sports in general and I play the violin and the piano. Looking forward to meet you!

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