Hungry for more

Hedge funds, those lightly regulated and enormously deep-pocketed investment vehicles for the affluent, are increasingly moving into venture. And with them, they’re bringing the vast cash reserves, quantitative know-how and swift deal-closing ability that have made them a force to be reckoned with on Wall Street. The hedge funds that are doing VC are proceeding carefully and only investing in deals where they have expertise from the public market. For most VCs, the hedge funds will be good deep-pocketed partners on follow-on rounds. But for a small number of VCs – namely, those that do large, late stage rounds – the hedge funds will be fierce competitors.

While the number of hedge funds investing in venture is still quite small, they are showing up in deals with more frequency, much to the annoyance of long-time VCs. Asked why he thinks so many hedge funds have jumped onto his turf, Joe Schoendorf, who has been with Accel Partners for nearly 20 years, says: “Greed and ignorance. We have seen this movie before.”

It’s too early to say whether hedge funds are in venture for the long haul or whether it’s just a fleeting fancy. What is clear, however, is that they are the furthest thing from dumb money. VCs who have invested alongside them report they are thorough in their due diligence, hyper-aware of the competition and adept in arranging complex financings such as roll-ups or prepping companies for public offerings.

What is the attraction for these investors? Erik Straser, a partner at Mohr Davidow Ventures, says it is all about valuations and allocations. The hedge fund investors are looking for private companies that will likely go public within two years. “They want to get in early at this cost of capital and not fight for an allocation later on,” he says.

Bill Burnham, a former Mobius Venture Capital investor and founder of small hedge fund Inductive Capital, says hedge funds are moving into venture in an effort to diversify into privately-held assets. “There’s a broad movement among a number of larger funds to build more of an active management business,” he says. “They have lots of capital to put to work, so it just makes sense to expand into different asset classes.”

Who’s who

This year, hedge funds have allocated more than US$1.5bn to dedicated venture investment funds, according to research from EVCJ’s sister publication VCJ. Venture investment across the hedge fund industry is higher, however, as most funds haven’t broken down how much they’re allocating to the sector.

Judging by the first three quarters of 2007, hedge funds are on track to invest in venture rounds valued at more than US$1bn this year. Leaders in the space include AllianceBernstein, a US$742bn asset manager that launched its venture arm this year and has already backed 10 companies, and D.E. Shaw Group, a US$37bn hedge fund operator that has made about a dozen venture capital investments and recently expanded its Silicon Valley investment team.

Other players include Och-Ziff, the US$27bn New York-based hedge fund that recently filed to go public and has been aggressively investing in venture capital and buyout deals over the past two years; The Galleon Group, a US$5bn New York-based hedge fund focused on information technology stocks, which recently closed a US$300m venture capital fund that will focus on late stage investments; and Tudor Capital, a US$15bn hedge fund that has invested in three start-ups since the beginning of July.

Today, hedge fund investments in venture still represent only a fraction of their total holdings. Should hedge investors take an active interest in private equity, their funding capacity would dwarf the existing venture industry. In the US today, there are approximately 9,000 active hedge funds that comprise a US$1.1trn industry, according to trade group the Hedge Fund Association. Venture capital firms, by contrast, invested just over US$26bn in all of 2006, and US$14.5bn in the first half of this year.

Friend or foe?

For venture investors, the question of whether hedge funds represent friend or foe varies with investment strategy. VCs in early rounds who have later partnered big funds tend to put them in the ally camp. With companies waiting longer to tap the IPO market, hedge funds can provide valuable interim financing, especially in life sciences, says Farah Champsi, a managing director at Alta Partners.

Such rivalry between VC and hedge investors is more likely to show up at Series D than Series A. At the early stage, hedge funds aren’t as big a threat, primarily because they lack the human capital to go after that business, says Burnham. But even early stage investors occasionally find themselves competing against a hedge fund. Looking at prior financings, there’s no standard venture deal for these investors.

And hedge funds are steadfastly sector-agnostic, too, pursuing deals in everything from biofuels to cancer drugs to pre-paid phone cards:

There’s a broad movement among a number of larger funds to build more of an active anagement business.
Bill Burnham, Mobius Venture Capital”

• Stark Investments led a US$21m second round of funding in September for Virent Energy Systems, a Madison, Wisconsin developer of processes for producing renewable fuels.

• Duquesne Capital Management led a US$41.3m Series D round in July for Agensys, a Santa Monica, California-based developer of antibodies for treating cancerous tumours.

• And Plainfield Asset Management and parent company The Cisneros Group led a US$40m round in August for Movida Communications, which markets pre-paid mobile phone services to Latino communities.

They could pass for VCs

Massive capital reserves aside, hedge funds are making efforts to blend in to the venture scene, both leading rounds and co-investing in VC-led deals. While best known as finance gurus, they’re also hiring scientists, techies and other dealmakers who seem very much like the venture capitalist next door.

Certainly D.E. Shaw’s Alex Wong fits that description. Before joining Shaw, Wong made venture investments in the semiconductor industry for Apax Partners and Intel Capital.

“I never looked at them as a hedge fund,” Raymond Johnson, CEO of Infinite Power Solutions, says of Shaw. “They always acted like, presented like, and talked like a VC.”

When raising an expansion round last year to fund a manufacturing facility to produce its tiny batteries for microelectronic devices, Infinite Power initially focused on venture investors. Johnson ended up picking Shaw to lead the oversubscribed US$38m round largely because of Wong’s expertise in building fabs.

Says Johnson: “My initial feeling was that hedge funds send you money, ask for a quarterly report, and you may never hear from them again. This is not that at all. This is very hands-on.” He points to a recent hire of a hard-to-fill vice-president of manufacturing position. Wong introduced several candidates and eventually referred Johnson to the recruiting firm that found the new VP.

It’s not uncommon to find hedge funds with deep industry expertise, says Paul Kanan, CFO at cancer drug maker Agensys, who approached several hedge investors while raising an expansion round earlier this year. “There were some we met who were purely financial people, but we met a lot of technically skilled people out there, too,” he says.

Agensys eventually settled on Duquesne, a Pittsburgh-based hedge fund to co-lead its US$41m Series D round in July. In addition to the money, Agensys added a strategic advisor to its board: Duquesne managing director Kenan Turnacioglu, a Ph.D. cell biologist who Kanan says also manages a US$500m portfolio of life sciences investments in the public markets.

Hedge funds are also doing their diligence. Susan Mason, a general partner at Onset Ventures, says she was impressed by the hands-on approach of co-investors at Alliance Bernstein, who participated in a recent US$27m round for mobile phone payment service Obopay. To get into the oversubscribed round, Mason recalls, the Alliance team put together a detailed analysis booklet on what they thought Obopay could be and how they could add value.

“They were very involved for a late stage investor,” she says. “I’m used to the later stage guys doing very little work in helping the company make introductions or build out their Rolodex.”

Hedge funds are also making an impression around the negotiating table. When it came time for thin film solar cell developer Nanosolar to raise another round last year, Mohr Davidow’s Straser recalls that some of the smartest people at the table had come from hedge funds. “These weren’t just randoms,” he says. “They were people who had made money in these industries already. They were hunting. We weren’t selling them on this market; they were already there.”

Hedge funds are picking the kinds of private finance transactions that most VCs shy away from.
Tom Simpson, Natwest Venture Associates

The proof was in the array of investments they had already made in the industry. Straser says he had been tracking the biggest shareholders of publicly-traded solar companies for some time. When SAC Capital Advisors and GLG Partners, hedge funds of roughly US$12bn each, approached Nanosolar, Straser knew they were deeply involved in solar. The two hedge funds joined with Jeff Skoll’s Capricorn Management, Christian Reitberger, Grazia Equity, Swiss Re and others in Nanosolar’s US$75m Series C in June 2006.

Fast rounds, high valuations

As hedge funds become more active in venture, entrepreneurs are turning to them for funding along with or possibly in lieu of venture firms. In raising its latest round, Agensys, for example, made a determined effort from the start to target hedge funds, though Kanan says he also talked to VCs and venture growth funds. In the end, Duquesne’s speediness in agreeing to terms gave it an edge in securing a lead spot in an oversubscribed round that also included Alta Partners and half-dozen other venture and private equity investors.

Kanan was pleasantly astounded by the rapidity with which Duquesne was able to close the latest round. From start to finish, the round took less than four months, with barely a hiccup in the negotiation process. “In my 20 years of fundraising,” Kanan says. “I’ve never experienced a financing that went that smoothly.”

Hedge funds have also been known to push up valuations. In late stage rounds, they “tend to be less valuation-sensitive than venture funds,” says Alta’s Champsi, also an Agensys board member. That propensity came across during fundraising, says Kanan, who observed that venture capitalists “seem to spend a lot more time on valuation than the hedge funds do.”

The presence of more, large asset managers – be they hedge funds or other institutional investors – in growth rounds is playing a role in raising deal size, too. In putting together September’s OANDA round, for example, NEA’s Kolluri says competing asset managers pushed up the valuation to the high end of his expected range. Investor demand was sufficient to push the price even higher, he said, but executives kept the round down somewhat by focusing on a few favoured backers.

Today, overall hedge fund investment levels are too low to put pressure on venture valuations except in isolated cases. Even so, the size of follow-on rounds is still on the rise. Among San Francisco Bay Area companies that raised follow-on rounds in the first half of the year, valuations rose by an average of 75%, according to a survey by law firm Fenwick & West. The increase was the highest in the survey’s five-year history.

Hedge edge?

For entrepreneurs, the most obvious appeal of a hedge fund is its ability to invest vast sums of money. With billions at their disposal, hedge funds are capable of providing start-ups with capital to fend off competitors and even, in some cases, to buy them out.

Granted, top-tier VCs can mostly match those offerings. But for private companies in sought-after funding rounds, hedge funds can offer a compelling sales pitch. Beyond vast capital, their strengths include a flexible investment timetable, connections to powerful publicly traded companies and experience in complex financings.

The latter appealed to Pay By Touch, a developer of biometric-based payment systems. When the San Francisco company needed to raise money two years ago, it turned away traditional venture capital and looked toward hedge funds. The company had previously raised US$50m in two rounds from investors including Mobius Venture Capital and the Gordon P. Getty Family Trust. It wanted more money to continue acquiring key patents and to accelerate its expansion.

Founder John Rogers didn’t want to lose control by selling more of the company’s equity. So for its next round of financing, the firm took out a US$75m loan. Och-Ziff led the financing with help from Farallon Capital Management and Plainfield Asset Management.

Pay By Touch also raised US$55m in convertible promissory notes – which could be turned into shares when the company prices its third round of financing. The Och Ziff-led round included the purchase of Mobius Partners’ stake in the company, for a 1.75x return, says Burnham, a former Mobius managing director.

To date, Pay By Touch has raised well over US$200m in debt and equity financing. Since the infusion from Och-Ziff, the company has made at least five acquisitions of companies in the payment processing, biometrics and loyalty marketing industries

If you think there’s a sector that is very interesting and might be consolidated, that’s not a
conversation you can have with VCs.
Ashfaq Munshi, Terabitz

Roll-ups aren’t beyond the capabilities of venture capital firms. VCs have occasionally spearheaded such transactions, but it’s not their bread and butter.

To the extent hedge funds are picking the kinds of private finance transactions that most VCs shy away from, they’re not a big threat to venture firms, says Tom Simpson, managing partner of Northwest Venture Associates. However, he adds: “If they’re just coming in to support the next Series A for the next Web 2.0 company, then it’s just a game of musical chairs, because there’s ample capital available for those sorts of investments.”

Certainly there’s ample capital for promising start-ups in other sectors too, particularly solar. Robert Ford, CEO of silicon solar panel maker Solaicx, says he had multiple venture suitors, but he considered the deep pockets associated with a big hedge fund investor in selecting D.E. Shaw as a backer. The five-year-old Santa Clara-based company closed a US$27m Series C round in April to fund a manufacturing operation in Portland. Ford says he went with Shaw both for its financial resources and for the operational expertise of Wong, who invested in solar cell manufacturer Q-Cells when he was with Apax. “We saw them as tier-one VCs who had the additional capability of added financing downstream,” Ford says.

Batting average

It’s too early to say if hedge funds make great VCs. So far, their investments have generated few exits. For the most part, those that have matured to exit have not generated the “home run” multiples VCs covet.

But hedge investors tend to have more modest ROI expectations than VCs, says Alta’s Champsi. In her experience, hedge investors have focused on selecting private companies close to exit rather than chasing 10x multiples.

“Because they have a sense of what the public markets are like, they have a good sense of when a company could potentially access that,” she says. And when a company does file for an IPO, “They could provide some credibility to the street as a quality buy-side fund that is already committed to the company.”

When hedge funds have made money on venture deals, they’ve often done so quickly. Och-Ziff, for example, invested in a US$21m expansion round for NewStar Financial, a provider of debt financing services, in March 2006 at a valuation of US$190m. The company went public in December and currently trades around US$11, with a market cap around US$400m. Och-Ziff had 4.8 million shares at the time of the offering.

Palo Alto Investors and Och-Ziff also profited from their investments in Amicus Therapeutics, which they made in 2005 at a valuation of US$83m and in 2006 at a valuation of US$184m. Amicus, a developer of treatments for genetic disorders, went public in late May and is currently valued around US$280m.

Other deals promise similarly fast returns. MAP Pharmaceuticals, which makes inhaled drug products, raised US$50m in a March round that included D.E. Shaw and seven other investors. Three months later, it filed for an IPO.

Stark Investments, meanwhile, is listed as a 2.4% stakeholder in Imperium Renewables, a biofuel company that filed to go public in May.

Stark also bought small stakes in two venture-backed Wisconsin companies that have gone on to exit this year, according to Scott Button, a managing director at Madison, Wisconsin-based Venture Investors, an early stage backer in those deals. One was TomoTherapy, a developer of cancer radiation treatment systems that went public in May, and the other was NimbleGen, a gene chip maker acquired by Roche in June.

As hedge funds build up a track record in venture, they’re also building up an impressive deal pipeline as entrepreneurs are also taking the hedge fund route, bypassing VCs altogether. Ashfaq Munshi, founder of online real estate resource Terabitz, is a case in point. Munshi says he turned to Tudor Capital for a US$10m Series A investment in July because it was able to move fast, offer funding for rapid acquisition and consolidation, and provide connections to critical corporations. The serial entrepreneur says he didn’t even approach venture capitalists to fund the round. “If you think there’s a sector that is very interesting and might be consolidated, that’s not a conversation you can have with VCs,” Munshi says. “They think it means you’re taking the eye off the ball instead of getting the ball to be bigger and come faster.”

So it looks like the hedge funds are here to stay, for the meantime at least and some even have their sights set on the deals of their European counterparts – watch this space.