Start-ups’ new money machine
Hedge funds and mutual funds, which usually invest in publicly traded companies, have lately poured billions of dollars into hot start-ups. Uber, Airbnb and Dropbox have been funded by non-venture-capital funds such as Wellington and T. Rowe Price. Other businesses with billion-dollar-plus valuations (so-called unicorns) have taken money from Fidelity and BlackRock, as well as hedge funds such as Tiger Global and Coatue.
These investors have had a huge impact on the overall venture market, especially in later rounds of funding for older companies. Last quarter, for example, even as traditional venture financing slowed down, the newbies stepped in. VC firms invested $11.3 billion during the first quarter of 2015, versus $13.7 billion in the last quarter of 2014. Even so, funding for start-ups hit a high of $17.7 billion in the quarter, from $15.6 billion in the fourth quarter of 2014, because hedge funds, mutual funds and private equity firms all put money on the line.
There’s been some worry over whether these public market investors are taking on too much risk when they invest in private companies. I’m not so sure this is an issue, especially for a huge asset manager like Fidelity, which has $808.9 billion in equity fund assets. Investing hundreds of millions of dollars in a handful of start-ups won’t bring down a player that big.
But all the money from public market investors could pose a risk to the start-ups themselves, because there’s a big difference in the way that investments from venture capital firms and public funds are structured.
When VCs raise money, their investors (known as limited partners, or LPs) are typically locked into the fund for five to seven years. If VC-backed companies hit a rough patch, the LPs know that they’re locked into that process. If the overall value of the venture firm’s portfolio falls, the LPs still have to tough it out.
Hedge-fund investors, on the other hand, can often take their money out of the fund every month or every quarter. Mutual-fund investors can usually take out their money whenever they want. The upshot is that investors can readily bail when the values of their funds go down - something that history shows they are more than willing to do. In turn, the funds have to sell stuff, including shares in start-ups, in order to return money to their shareholders.
During the dot-com crash 15 years ago, “many hedge fund and mutual funds faced massive redemptions when the market cratered and they had to find ways out of their [private company] positions,” said Glenn Solomon, a partner with the venture firm GGV Capital.
That fire sale caused a secondary market for venture positions tied to those fund positions to spring up, and the shares were often sold at a deep discount - driving down the overall value of the start-ups.
“It was tough on management teams, which were often facing challenges in their companies, to all of a sudden face shareholder pressure, too,” Solomon said.
We saw a similar and dangerous mismatch between long-term investments and short-term funding during the financial crisis. All sorts of entities, from the bond insurance companies to General Electric to AIG, took short-term money and invested it in securities that seemed safe but turned out to be risky and illiquid.
Public market investors today have tried to mitigate some of the risk of investing in illiquid private companies by investing in those that seem to be on the verge of going public. That’s a reasonable approach, except that many private companies have decided to keep taking free-flowing private funds rather pursue an IPO.
To forestall similar problems, some investors, such as Coatue and Tiger Global, have created investment vehicles with long lockups for their LPs to eliminate the risk of a liquidity mismatch. Others, including BlackRock, have pushed private companies to grant liquidity guarantees, even though the shares are privately held.
“Founders should ask questions about the objectives and intentions of their potential investors and also about the source of and permanency of the capital being provided,” Solomon said. If they don’t have a clear sense of what they’re agreeing to when they take money from public investors, they could get burned.
The author is a Bloomberg View columnist who writes about technology, innovation, and the cult and culture of Silicon Valley.
by Katie Benner