Hedge Fund Rising

Editor’s note: Glenn Solomon is a Partner with GGV Capital. Some of his recent investments include Pandora, Successfactors, Nimble Storage, Isilon, Domo, Square, Zendesk, Quinstreet and AlienVault. His personal blog, goinglongblog.com, focuses on growth-stage entrepreneurs who are thinking big. Follow him on Twitter @glennsolomon.

Scrolling through reports of recent venture financings, the names of the firms involved has changed quite a bit over the past few quarters. Of note, hedge funds have entered the later-stage, pre-IPO investment arena in a meaningful way. Firms like Coatue Capital (Snapchat, Box), Valiant Capital (Pinterest, Evernote) and Tiger Global (One Kings Lane, Nextdoor) are not new to venture investing but appear to be ramping their pace and investing in some of the most sought after private companies globally.

Similarly, several other hedge funds are entering the market and large, long-only fund managers such as T. Rowe Price (Pure Storage, New Relic) and Fidelity (Pinterest, MongoDB) seem to be increasing their activity, as well.

As Leena Rao reported last month on TechCrunch, hedge funds often impress founders with their ability to move quickly and pay higher prices than VCs. Hedge funds clearly present a compelling option. So, for founders and early-stage VCs, understanding why hedge funds are getting more active in the venture market and evaluating the pros and cons of taking their capital is worthwhile.

Motivations – Why Is This Happening?

Although my firm, GGV Capital, has been outbid more than once recently by hedge funds, I think the involvement of hedge funds in the venture capital asset class, especially in the pre-IPO stage, is a healthy thing.

Make no mistake, hedge fund managers tend to be some of the smartest and savviest investors. Although the prices they’re willing to pay may seem high sometimes, they routinely have sound motivations.

First, many companies are going public later nowadays, so if a hedge or mutual fund waits until an IPO, the companies are now much more mature, often with their most rapid growth behind them. Growth investors, who want to catch those years when a company is expanding really fast, opening up unpenetrated markets and going global, are forced to invest in private rounds, rather than wait for an IPO.

Second, the paucity of growth in today’s public company universe is leaving hedge and mutual funds with fewer options, driving their interest in faster growth IPOs, and in the financings one to two rounds earlier, while these companies are private, as well.

And finally, because the typical IPO hasn’t grown in size in many years, allocations are usually small, and even in the aftermarket, it’s hard to build a big position in newly public companies. Most successful hedge funds and larger mutual funds need to build sizable positions (i.e. many tens of millions of dollars) for it to make sense to hold a stock. Investing pre-IPO is a way for these funds to get a head start building a position.

Implications – What You Need To Consider

Given this new reality, what are the implications for entrepreneurs? There’s not a black and white answer. Many management teams and boards with whom I speak laud the benefits of taking money from hedge funds and/or mutual funds. For example, they often move quickly, saving companies precious time. Additionally, as public investors, their typical return expectations are lower than those of VCs, so, as mentioned above, they’re also often willing to pay higher prices and are less focused on deal terms than VCs. Finally, these funds are usually “hands off” investors, which is a positive for many companies, where there are already several VCs involved.

That said, hedge funds in particular tend not to invest with 5-10 year investment horizons. In fact, most hedge fund vehicles offer their investors quarterly redemption options. So, while most VCs will continue to support a management team that hits a rough patch or decides to double down on a new strategy, prolonging the time to an IPO substantially, hedge fund investors might be in a different position.

If a hedge fund’s investors head for the door due to macro or fund-specific reasons, the funds need to raise cash. During such events, venture capital positions aren’t desirable and the same goes for long-only funds facing redemptions. In these situations, the 10-year vehicles most VCs invest from are naturally more patient, and can help reduce risk of shareholder consternation.

Several hedge funds have attempted to remedy this issue by creating separate, longer term vehicles. This makes sense, and the test for these funds will come when the next big public market downturn occurs and fund managers feel pressure to deliver cash to their investors.

The Verdict – Get Prepared

Entrepreneurs should be proactive in thinking through this trend. Leveraged in the right away, hedge and mutual funds can be terrific investment partners for the right companies. Yet, there will be cases specific to a company or generalized to the overall public markets that could impact a situation and change the cadence of the investor-founder relationship quite abruptly. As with any funding source, founders would be wise to run through these scenarios when evaluating financing options, even though we’re currently in an exciting up market. Things always change and do so quickly.