Venture Capital
How hedge funds are leading the race to stake startups
April 19, 2021 View comment (1)
As is customary among VCs, Vertex US tries to build relationships with founders in hopes that the startups will agree to let the early-stage firm lead their next round of financing. After recently meeting with one such founder about 30 times and helping the company put together diligence materials, Vertex was sure that they were the frontrunner to lead its Series A.
But at the last minute, a crossover fund stepped in with a proposal at a valuation that was about $40 million more than Vertex was offering.
"The founder told us that they wanted to work with us, but the other bid was an order of magnitude higher," said Chase Roberts, a principal with Vertex US. The firm's small fund, its second vehicle of $150 million, precluded Vertex from writing a larger check, and Roberts had no choice but to step aside.
These situations where traditional VC firms are significantly outbid by hedge funds and other crossover investors have become a frequent occurrence in the red-hot venture capital market.
The trend of wooing fast-growing startups by offering to pay as much as 50% to 100% higher than traditional VCs is led most famously by Tiger Global and Coatue Management.
But the practice of paying significantly more for a chance to get into hot companies is increasingly common at other multi-strategy firms such as Altimeter Capital, Dragoneer Investment and D1, venture capitalists said. Other firms they cited include growth equity investor Insight Partners and Addition, a VC-focused offshoot of Tiger Global.
While hedge funds have dabbled in venture since around the dot-com bubble, their presence in the asset class was never as prominent as it has been over the last year.
A little over three months into 2021, this group has participated in 168 deals, nearly 80% of the 214 they closed last year and already topping the 155 investments they made in 2019, according to PitchBook.
"The big difference now is the speed of investing, and valuations are like nothing else I've seen in my more than 20 years in venture," said a veteran VC investor who asked to remain anonymous because he regularly works with these firms.
These investors' strategy for getting into promising startups is to knock out all competition by offering terms most traditional VC firms cannot match. "It is not like there are bidding wars. They are changing dynamics of the rounds altogether," Roberts said.
"It used to be if you are up against other investors, which is most of the time, the valuation differences between bids were between $5 million to $15 million at the Series A," he added. "Founders sometimes took lower offers because their dilution was only a few percentage points higher. But when you get these giant swings in value, it puts founders in tough situations."
What stands out to Roberts and other traditional investors is how quickly Tiger Global and some other hedge funds decide to invest.
Another early-stage investor recently told Roberts that he had received a preemptive term sheet for one of his portfolio companies but decided to check if Tiger Global would up the price. This investor took a screenshot of the offer and key statistics for the company and sent them via text message to someone at the hedge fund, Roberts said. "Within 48 hours he had a term sheet from Tiger for about $50 million more than the previous valuation," Roberts said.
Roberts said that he also heard of an instance when Tiger Global doubled the terms of what a growth-stage VC was offering for a company—from a $125 million round at a $1 billion valuation to $250 million at a valuation of $2 billion—after reviewing the company for a mere 48 hours.
"Tiger is essentially indexing late-stage venture by having their research team figure out who are the best two or three companies in each category and geography. They then preempt the next rounds of these companies with a term sheet that is at a significant premium to the last series of financing," the SaaS-focused investor said.
Tiger Management and some of their counterparts are also known for not taking board or board observer seats. "They are not selling help, they are not selling recruiting, they are not selling that ‘I am available for an 11 p.m. call on a Friday night when your biggest customer just fired you and you are wondering what to do,'" said Roberts. "They are quite literally selling money."
The veteran VC called this approach "private stock picking."
"Old-line venture firms had the rule of needing to have 20% of the company and a board seat, but these firms don't subscribe to this rule," he said.
Since the scarcest resource in Silicon Valley is access and not capital, hedge funds are happy to overpay at earlier stages for a chance to invest hundreds of millions into winning companies before they go public, the SaaS-focused VC explained. "‘Loss leader' is too strong of a word, but what they are doing is buying access," he said.
According to the veteran VC, these firms want to invest in the best companies at almost any price because their thinking is that, over the long term, they will make money.
There are multiple reasons behind hedge funds' push into venture. With the number of public companies down by 50% over the last two decades, there are fewer investment opportunities in the stock market. Companies are staying private for longer and are growing significantly before hitting the public markets. Couple this with unusually strong exit possibilities, such as those garnered in the IPOs of companies like Snowflake, Airbnb and Roblox, and the attraction of venture investing becomes apparent.
What distinguishes hedge funds from traditional VC firms is not only their colossal fund sizes, like Tiger Global's $6.7 billion vehicle, or their ability to invest in venture from the entire asset base, which is more than $15 billion in the case of D1 Capital, but also their capacity to hold portfolio companies post their public market debuts.
While most firms mentioned in this article win deals by paying more than everyone else, their strategies are far from identical.
For instance, Tiger Global is most active in Series B, C and D. Coatue invests across stages, including backing seed and Series A deals from its $700 million early-stage fund, and occasionally takes board seats. Addition, a firm founded by ex-Tiger Global partner Lee Fixel, has a penchant for seed and early-stage, but he eschews board participation.
Another firm that invests at high velocity and offers companies aggressive terms is Insight Partners. While Insight is not a hedge fund, some traditional VCs find the firm's approach to venture investing concerning.
"Insight is investing like it's going out of style. They are raising bigger and bigger funds and deploying them faster and faster," the veteran VC said about the growth equity firm, which invests from seed-stage deals to LBOs.
The New York-based firm closed a $9.5 billion fund last year and is now reportedly seeking a new fund of at least $12 billion. Insight Partners' long list of public and private LPs—which includes Alaska Permanent Fund and CalPERS, the largest public pension fund in the US—appear to be on board with their GP's aggressive investment style.
At the same time, everyone in the industry needs to have a strong conviction about startups they want to back before a potential portfolio company begins raising. "There is a lot more preemption; otherwise a traditional firm won't win the auction. That's why you see rounds every six months or three months now," the SaaS-focused VC said.
"We just led a Series A in a company, and three weeks after we closed, one of these hedge funds reached out and said, ‘Whenever you raise again, we would love to preempt that round. We already have our diligence ready to go,'" the VC said.
For now, many of these hedge funds are increasing their investment velocities and doubling down on their approach.
But if the valuation environment changes suddenly, it may be painful for startups that raised at exuberantly high valuations.
"We'll see how the behavior of these firms changes in a correction, but I don't think they are leaving venture capital," the veteran investor said.
Related Read: After Snowflake windfall, Altimeter Capital captures dealmaking spotlight
Clarification
This article has been updated to clarify the investment strategy at Addition. (April 19, 2021)
Featured image by Justin Setterfield/Getty Images
But at the last minute, a crossover fund stepped in with a proposal at a valuation that was about $40 million more than Vertex was offering.
"The founder told us that they wanted to work with us, but the other bid was an order of magnitude higher," said Chase Roberts, a principal with Vertex US. The firm's small fund, its second vehicle of $150 million, precluded Vertex from writing a larger check, and Roberts had no choice but to step aside.
These situations where traditional VC firms are significantly outbid by hedge funds and other crossover investors have become a frequent occurrence in the red-hot venture capital market.
The trend of wooing fast-growing startups by offering to pay as much as 50% to 100% higher than traditional VCs is led most famously by Tiger Global and Coatue Management.
But the practice of paying significantly more for a chance to get into hot companies is increasingly common at other multi-strategy firms such as Altimeter Capital, Dragoneer Investment and D1, venture capitalists said. Other firms they cited include growth equity investor Insight Partners and Addition, a VC-focused offshoot of Tiger Global.
While hedge funds have dabbled in venture since around the dot-com bubble, their presence in the asset class was never as prominent as it has been over the last year.
A little over three months into 2021, this group has participated in 168 deals, nearly 80% of the 214 they closed last year and already topping the 155 investments they made in 2019, according to PitchBook.
Global VC deals by select investors
"The big difference now is the speed of investing, and valuations are like nothing else I've seen in my more than 20 years in venture," said a veteran VC investor who asked to remain anonymous because he regularly works with these firms.
These investors' strategy for getting into promising startups is to knock out all competition by offering terms most traditional VC firms cannot match. "It is not like there are bidding wars. They are changing dynamics of the rounds altogether," Roberts said.
"It used to be if you are up against other investors, which is most of the time, the valuation differences between bids were between $5 million to $15 million at the Series A," he added. "Founders sometimes took lower offers because their dilution was only a few percentage points higher. But when you get these giant swings in value, it puts founders in tough situations."
What stands out to Roberts and other traditional investors is how quickly Tiger Global and some other hedge funds decide to invest.
Another early-stage investor recently told Roberts that he had received a preemptive term sheet for one of his portfolio companies but decided to check if Tiger Global would up the price. This investor took a screenshot of the offer and key statistics for the company and sent them via text message to someone at the hedge fund, Roberts said. "Within 48 hours he had a term sheet from Tiger for about $50 million more than the previous valuation," Roberts said.
Roberts said that he also heard of an instance when Tiger Global doubled the terms of what a growth-stage VC was offering for a company—from a $125 million round at a $1 billion valuation to $250 million at a valuation of $2 billion—after reviewing the company for a mere 48 hours.
'Private stock picking'
While many traditional VCs are dismayed by what they see as Tiger Global's cursory diligence, the firm has a deliberate approach to investing in venture, according to a SaaS-focused VC who also asked to remain anonymous. This investor said he spoke last year to John Curtius, one of the key partners at Tiger Global, about the firm's strategy."Tiger is essentially indexing late-stage venture by having their research team figure out who are the best two or three companies in each category and geography. They then preempt the next rounds of these companies with a term sheet that is at a significant premium to the last series of financing," the SaaS-focused investor said.
Tiger Management and some of their counterparts are also known for not taking board or board observer seats. "They are not selling help, they are not selling recruiting, they are not selling that ‘I am available for an 11 p.m. call on a Friday night when your biggest customer just fired you and you are wondering what to do,'" said Roberts. "They are quite literally selling money."
The veteran VC called this approach "private stock picking."
"Old-line venture firms had the rule of needing to have 20% of the company and a board seat, but these firms don't subscribe to this rule," he said.
Since the scarcest resource in Silicon Valley is access and not capital, hedge funds are happy to overpay at earlier stages for a chance to invest hundreds of millions into winning companies before they go public, the SaaS-focused VC explained. "‘Loss leader' is too strong of a word, but what they are doing is buying access," he said.
According to the veteran VC, these firms want to invest in the best companies at almost any price because their thinking is that, over the long term, they will make money.
There are multiple reasons behind hedge funds' push into venture. With the number of public companies down by 50% over the last two decades, there are fewer investment opportunities in the stock market. Companies are staying private for longer and are growing significantly before hitting the public markets. Couple this with unusually strong exit possibilities, such as those garnered in the IPOs of companies like Snowflake, Airbnb and Roblox, and the attraction of venture investing becomes apparent.
What distinguishes hedge funds from traditional VC firms is not only their colossal fund sizes, like Tiger Global's $6.7 billion vehicle, or their ability to invest in venture from the entire asset base, which is more than $15 billion in the case of D1 Capital, but also their capacity to hold portfolio companies post their public market debuts.
While most firms mentioned in this article win deals by paying more than everyone else, their strategies are far from identical.
For instance, Tiger Global is most active in Series B, C and D. Coatue invests across stages, including backing seed and Series A deals from its $700 million early-stage fund, and occasionally takes board seats. Addition, a firm founded by ex-Tiger Global partner Lee Fixel, has a penchant for seed and early-stage, but he eschews board participation.
Another firm that invests at high velocity and offers companies aggressive terms is Insight Partners. While Insight is not a hedge fund, some traditional VCs find the firm's approach to venture investing concerning.
"Insight is investing like it's going out of style. They are raising bigger and bigger funds and deploying them faster and faster," the veteran VC said about the growth equity firm, which invests from seed-stage deals to LBOs.
Global VC deals by Insight Partners
The New York-based firm closed a $9.5 billion fund last year and is now reportedly seeking a new fund of at least $12 billion. Insight Partners' long list of public and private LPs—which includes Alaska Permanent Fund and CalPERS, the largest public pension fund in the US—appear to be on board with their GP's aggressive investment style.
While on the whole, hedge funds are a threat to traditional VCs, early-stage investors appreciate gargantuan markups on their portfolio companies if the next round is led by a firm like Tiger Global.
At the same time, everyone in the industry needs to have a strong conviction about startups they want to back before a potential portfolio company begins raising. "There is a lot more preemption; otherwise a traditional firm won't win the auction. That's why you see rounds every six months or three months now," the SaaS-focused VC said.
"We just led a Series A in a company, and three weeks after we closed, one of these hedge funds reached out and said, ‘Whenever you raise again, we would love to preempt that round. We already have our diligence ready to go,'" the VC said.
For now, many of these hedge funds are increasing their investment velocities and doubling down on their approach.
But if the valuation environment changes suddenly, it may be painful for startups that raised at exuberantly high valuations.
"We'll see how the behavior of these firms changes in a correction, but I don't think they are leaving venture capital," the veteran investor said.
Related Read: After Snowflake windfall, Altimeter Capital captures dealmaking spotlight
Clarification
This article has been updated to clarify the investment strategy at Addition. (April 19, 2021)
Featured image by Justin Setterfield/Getty Images
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