Venture Capital - Becoming Like the Hedge Fund Industry?

There was an article this weekend in the Mercury News discussing the emergence of "microfunds" - $10-$15 million funds run by former entrepreneurs and/or VCs doing really small (angel-like) deals. Some excerpts from the article are provided here. I have highlighted some particularly relevant points.

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Some of these investors are frustrated with the structure of venture capital partnerships, while others want to invest in extremely small start-ups that traditional VC firms that have been ballooning in size have begun to ignore.

``It's sort of the next step of angel investing,'' says Mark Heesen, the president of the National Venture Capital Association. ``VCs just don't have ability to invest in extremely early stage companies any more, and someone needs to do that in organized fashion. So I think there is a market there, that the timing is right.''

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Then again, the idea -- for VCs, angels, and microfund managers alike -- is to spin investments into big profits, and growing numbers of investors think seeding start-ups is the way to do that. ``People are trying to figure out the industry right now,'' says venture capitalist Stewart Alsop, who co-founded a small venture firm in San Francisco last year after leaving New Enterprise Associates, which manages billions of dollars. ``The consensus seems to be that the more dollars you put to work at any one time, the less likely you are to get great returns.''

Bill Burnham, a Wall Street-analyst-turned venture capitalist who has worked with both Softbank Capital and Mobius Venture Capital, is behind one of the funds, a $10 million vehicle called Inductive Capital, in Palo Alto. Burnham raised the money from more than two dozen individuals -- mostly VCs -- and he plans to use both his background as a public technology stock analyst and his venture industry connections to identify and invest in undervalued public stocks.

I find this very, very interesting. As a hedge fund watcher, a hedge fund investor, an angel investor and as one who has taken venture capital financing, this is a pretty rich topic. I am first amazed at the pure innovation taking place in both the public and private markets. When I was in the derivatives markets I saw this innovation first-hand; customized OTC strategies, convertible instruments of every stripe, distributed structured products, CMOs, CBOs, etc. But I've got to say that innovation in venture capital and private equity - deal structures, partnership structures, public listings of funds held by private partnerships, etc. - is pretty impressive as well. Innovation in finance just keeps going, and it is a beautiful thing to behold. But this innovation arises when trying to solve a critical problem - how to make more money more efficiently in an increasingly competitive marketplace.

So why did this particular topic - VCs doing microfinance - spur this post? Well, it occurred to me that some of the issues and opportunities in venture capital really parallel those of the hedge fund industry. Some of the key themes include:

The perils of bigness #1: The more you've got, the more you've got to deploy. And this isn't always a good thing. Empirical research has shown that hedge funds, on average, do best early in their existence. Why? Managers have laser focus on success, they are investing a manageable asset base, they are able to pursue a single strategy without hitting scalability constraints, to name a few reasons. We have seen a proliferation of mega-VC funds (read: multi-strategy hedge funds) over the past five years, and it is taking increasingly large investments in order to move the meter for these funds. So what do these funds have to do? Either do later-stage deals, which necessarily have lower returns than early-stage deals (read: investing in a diversified array of strategies which tends to dampen both risk and return) or swing for the fences in size (Amaranth, anybody?). Either way, very few firms are successful managing this delicate balancing act (Fortress, DE Shaw, Farallon, to name a few).

This trend towards micro-VCs is, in effect, creating a class like those of emerging hedge funds who are expected to post outsized returns due to their ability to tap ideas overlooked by the larger funds, while preserving the laser focus on optimizing returns across a smaller, easier-to-manage portfolio of deals. This is the "barbell" discussion in the hedge fund industry I've had so many times - big, institutional, less risky with lower returns versus smaller, less formalized, riskier with potentially greater returns. It's the same gig.

The perils of bigness #2: Then there is the issue of motivation. When you are running billions, the management fees alone are enough to keep you in Class A office space with a panoply of exoticars in the parking lot. On balance, it has got to be hard to keep the edge when you've got all these trappings of success.

So what of our VC microfunds? Well now, if you're running $15 million the money you're pulling in isn't enough to pay the insurance bill on your Carmel estate. It isn't enough to pay you, an analyst and an assistant, much less anything else. So you are running lean. Very lean. You're hungry. You have to win. You get the point. The alignment of manager/investor returns couldn't be more pure.

The beauty of smallness - VC financing for every stage of the company life cycle: For those of you close to trading, we have seen the ability to trade every strip of the capital structure migrate from the bottom right to the top right. First the cash instruments, then equity derivatives, convertible bonds, credit default swaps, and now bank loan derivatives. The juice is being squeezed out of every layer of the balance sheet, pushing us toward a modular, building block world. Each piece is finding its way to the firm that is best suited to hold it and will pay the most for it, and if inefficiencies in these prices emerge traders will step in to force convergence. This is cool.

So it used to be that we had VCs that did Series A deals, then Series B deals, then as funds got bigger C, D, E and F deals. Any G deals on the table (except for in biotech?). But now we've got guys who aren't pursuing the Gs - but the seed deals! So these VCs are really providing finance in the realm of the angel groups (run as a sole proprietorship, however). Potentially much easier to deal with than angel groups, especially if one is dealing with a super-experienced micromanager the likes of a Bill Burnham. This is quite an interesting development, and now it appears that VCs run the gamut from seed all the way up to mega-institutional. Again, this really feels like the evolution in capital structure arbitrage specifically and the hedge fund industry in general - the Venture Capital industry has become a "one-stop shop." And this innovation has happened for that purest of reasons - simply to make more money more efficiently.

I am fascinated to see the efficiency of the markets, be they public or private, as innovation happens to meet market needs. I think the micro VC strategy, like emerging hedge funds, holds the promise of attractive risk-adjusted returns. The format is right, the market need exists and opportunities abound. But it still comes back to the same issue: it's the quality of the manager that counts. Nothing else matters. Do you have the due diligence wherewithall to make the call? You be the judge.

ADDENDUM - 10/4/06

After reading Bill Burnham's blog about his particular micro fund, Inductive Capital, he is focusing on specifically on leveraging his private markets technology experience to make investments in public equities. This is slightly different than being a VC micro manager, but represents a shift in the same direction - highlighting the convergence of the public and private markets, hedge funds/private equity and VC. His fund is technically a hedge fund, notwithstanding its small size. Therefore, I fully expect that he will use VC-type techniques (active management, leveraging a network of advisors and industry contacts, structuring VC-type instruments in the form of PIPEs, etc.) to extract value from small-capitalization technology companies. I think Bill's area of focus is great and he will do tremendously well. Inefficiencies abound in this segment of the market and a professional with Bill's deep expertise, track record and network should be able to add real value and generate true alpha.

Comments

[Roger]

Yaser, I think the issue of patience is a good one to raise. The issue to me is that it creates a bifurcated hedge fund model - one with liquid assets (which can be currently and accurately marked-to-market and which should attract current compensation) and one with illiquid assets, i.e., PIPES, private equity, venture capital (which CANNOT be currently and accurately MTM and which SHOULD NOT attract current compensation). HFs can afford to be patient if they are getting paid currently under the existing HF model while the assets remain illiquid. This creates an asymmetry that can give rise to abuse via side pockets, which is something I've written about extensively. This can be addressed via separate share classes, one which is akin to the tradtional HF model and one which is more similar to the traditional PE model. If the market moves in this direction, great. If not, I personally think this creates an unfair structural advantage for HFs that is not sustainable long-term.

[Yaser Anwar]

The NVCA doesn't keep records of hedgefund involvement in private-company finance, but says that anecdotal evidence suggests it is. With hedge funds setting their sights on young companies before they go public, it is not surprising that venture capitalists worry about losing out on potential returns, especially in the more secure later stages of private financing.

Before I end, I'd like to ask, if VCs are becoming HFs, the big concern should be if VCs can be patient enough to generate the needed returns? As we know a majority of the HFs are short-term focused, and to be successfull in VCs, one has to be patient.

What do you think Mr. Ehrenberg?

Readers will enjoy the following links pertaining to the topic:

http://billburnham.blogs.com/burnhamsbeat/2006/02/the_25_solution.html