As venture capital (VC) firms compete with hedge funds for deal flow in the startup venture space, does this mark an evolution of the market or a phenomenon that will fade with time? Who does it benefit and what should entrepreneurs make of hedge funds as potential investors?
A report from Livemint recently noted that hedge funds and mutual funds have entered venture capital space in the Indian market, creating a state of intense competition with VC’s for dealflow and investments in the early stage ventures. This trend reflects developments in the US market, as well as across the world.
Tiger Global Management – a multi-stage hedge fund that does early stage venture, later stage venture, and private equity investments – in particular has distinguished itself in the field of private technology investment. But is this infusion of high-risk investors a positive development for entrepreneurial ecosystems?
The Indian entrepreneurial ecosystem is seeing increasing involvement by hedge funds and other institutional investors, who invested $4.35 billion in private deals in India in 2014, more than quadruple the $883 million invested in 2013, according to data from CB Insights, a New York-based venture capital intelligence firm.
In Q1 2014, hedge funds invested $1.36 billion across 69 private companies in India, counting funding rounds closed alongside with VC funds. Hedge funds active in the Indian venture capital space in 2014 include, Valiant Capital Partners, Steadview Capital Management and Hillhouse Capital Group.
“In some of the situations, VCs have been outbid on valuations, or hedge funds have moved too fast, they have put money on the table and closed the round, or in some cases the cheque sizes have gone beyond what VCs would be comfortable with,” said Nitin Bhatia, managing director at Signal Hill, a tech-focused foreign investment bank, in a statement to Livemint.
Hedge Fund Operations
Hedge funds tend to invest across several asset classes, in both in public and private companies. By comparison, VC funds focus their investments on early-stage private firms and venture capital asset classes, exchanging capital for equity in an asset that operates in conditions of high uncertainty.
Hedge funds, as a rule, do not get involved in the operations of their portfolio companies. By contrast, VCs s take up board seats and nurture the companies during the entire period they stay invested, taking on the role of activist investors.
According to investment bankers, hedge funds that usually invested only in late-stage investment rounds are now becoming more comfortable with investing at earlier stages such as Series B and C rounds along with VC investors, as well as making investments with smaller ticket sizes.
This is because hedge funds often maintain flexible mandates, pricing and valuations, as well as the capacity and permission from their limited partners (LPs) to fund private deals, as well as. This flexibility also allows founders to access capital more rapidly than with a VC, due to the due diligence now being conducted by hedge funds.
“Hedge funds which were earlier investing in late stages such as Series D and E have now started to invest in Series B and C rounds. Mostly, these funds are trying to invest in companies they think will become potential leaders. There is a strong belief that if you are the leader, then there will be an independent path to an IPO (initial public offering) or a strategic firm will see value and acquire you,” explained Bhatia to Livemint.
Startup venture founders in India seem content, if not happier, with the quick decisions, easier terms and high valuations offered by the hedge funds. Yashish Dahiya, co-founder and CEO of Policybazaar, observed: “Their terms are far easier and they do not take the same amount of time that venture capital funds were taking to close deals. Also, access to capital is no longer a problem and capital is not the barrier to entry any more.”
Policybazaar recently raised a $40 million Series D round in April 2015 from hedge fund Steadview Capital, in addition to PremjiInvest, Tiger Global, Ribbit Capital and ABG Capital, according to data from Crunchbase.
Dahiya has noted that historically, strong ideas and ventures lose out due to being unable to raise the necessary capital. In his opinion, the entry of hedge funds into the VC space is a solution to this problem, with their lower levels of engagement when compared to VCs also a positive development, as they have neither operational involvement nor intent and operate on a five to seven year horizon with reference to their investment.
Tiger Global Management was the most active hedge fund in private technology firm investments, participating in over 80 private company transactions totalling $3.75 billion in the 2010-2014 period, spanning India to Russia and the United States. These deals were focused on companies at their Series B and Series C stages.
In 2010, Dow Jones reported that VC’s invested $37.7 billion in 4377 deals in companies based in the US, Europe, Canada, Israel, mainland China and India, according to Dow Jones VentureSource. This represented a 14 percent increase in investment, but only a 2 per cent increase in deal activity from 2009, when $33 billion was raised for 4299 deals.
Commenting on this in 2010, Jessica Canning, global research director for Dow Jones VentureSource, said, “In China and Israel, investment growth significantly outpaced deal activity as investors favored mature companies, which often require larger rounds.”
Canning added, “Several venture hubs – including China, India and Israel – also saw their highest median deal sizes on record, a sign of maturing venture industries, while growth was more modest in the US and Europe, which have established venture environments.”
With this in mind, VC firms note a downside to this change in the profile of investors, pointing to a rapidly jump in valuations. Valuations and expectations could be misaligned, with the focus on raising large amount of capital without building and maintaining traction by the startup venture. However, more traditional bankers may disagree with the notion that hedge funds will look to exit and churn investments quicker than VCs.
In a statement to Livemint, Ashish Bhinde, executive director of Avendus Capital, opined: “Given the long-term growth potential, valuations are relatively expensive in the Indian market. But if these investors stay invested for, say, three-five years, then they will definitely make good returns.”
Avendus closed the highest number of digital media, e-commerce and technology deals in the Indian market in 2014. With this in mind, Bhinde believes that hedge funds are looking to stay invested for at least two to four years prior to exiting the venture.
Bhinde added, “Most of these funds generally have an allocation ranging from 5 per cent to 25 per cent of their fund for investments in private companies. Generally, these funds do not invest with the perspective that they have to exit these investments in one or two years.”
In response to this phenomenon, some VCs have adapted their investment theme and thesis, shifting towards early stage investments and making investments with smaller ticket sizes, identifying interesting niches and curating deal flow in that segment.
In some cases, the venture may end up raising significant funding without underlying traction to justify such capital.
However, it also appears to be a repeat of history, according to a TechCrunch report. For early-stage entrepreneurs seeking Series B/C and growth funding, more available capital is a positive development, with hedge funds being able to be flexible on pricing, as well as tending to give founders higher valuations that VC’s may balk at.
But the infusion of capital into startup ventures and the higher valuations attained also fuels the perception that of a bubble in the startup space, and the spectre of that bubble collapsing.
The implications for startup ecosystems in Southeast Asia and the Asia Pacific will be interesting, to say the least, if hedge funds in the regions startup ecosystems start replicating the behaviour of their Indian and North American counterparts. The ecosystems are still developing, with a high volume of venture capital opportunities present in the e-commerce, logistics, fintech and mobile spaces.
Currently, a mix of traditional VC money is coupled with corporate venture capital, hedge funds, private equity investors and sovereign wealth funds infusing capital into the venture capital asset class globally. Notable examples are Temasek’s investments in healthcare startup Hello and participation in Airbnb’s latest round of funding.
The contemporary VC business model relies on targeting a higher multiple for an investment tranche, with the need to price and value startups, to optimise for this. VCs operate on a commitment basis and do not collect entire funds at once. They also often limit themselves to specific sectors or business cases, unlike hedge funds which are considerably more versatile.
TechCrunch observed that Snapchat had raised entire rounds from hedge funds, which tend towards being passive investors and are not as involved in operations or board-level decisions as a seasoned VC might.
However, the downside of this reduced accountability is a lack of long-term commitment, as hedge funds will aim to offload stock once a venture becomes distressed. Most VCs are committed to their portfolio firm through the challenges presented – not necessarily the case for hedge funds.
According to TechCrunch, hedge funds entering early stage private-company investing is an evolutionary step and part of the unbundling of the company building – which VCs and angel investors possess deep expertise in – from financial capital.
This brings more funding to startups from non-traditional sources like hedge funds, family offices and other alternative sources. As Asia Pacific startup ecosystems mature and develop their own financial models, we are likely to see the entry of more hedge funds and family offices raising their capital with venture capital asset classes, in addition to the growth of more investor networks and communities.