Will there ever be a shake-out in the Venture Capital industry?

Whether or not there will be a “shake out” in the venture industry depends on how you define it. If it means that certain formerly prestigious VC firms will close up shop and wind down, then yes. If it means a sharp decline in the number of venture firms, then no. 

I look to the hedge fund industry for an analogy of how an alternative asset class has dealt with turmoil. Back in 2006, my original thesis was that the hedge fund industry would begin to resemble a barbell (as measured by assets under management), with a bubbling cauldron of smaller start-up funds focused on alpha at small scale, while a group of large asset management titans with best-in-class compliance, control and reporting environments would reinforce their already strong positions. Firms in the middle would have a hard time, as they lack the resources to compete with the largest firms while having “alpha at scale” problems not felt by the smaller firms. While small firms have jumped to the mega-class and some larger firms have imploded, I believe my thesis has largely been borne out.

Venture, unlike hedge funds, doesn’t scale as well due to the illiquid nature of the asset class (and therefore being difficult to risk-manage using quantitative analysis) and the time required to manage a single investment. Also, the costs of compliance, reporting and control are much more easily attained by smaller firms through outsourced service providers, and once a firm achieves a certain scale (somewhere between $50-$100 million in committed capital), I’d argue that the competitive advantages of scale as it relates to running the operation has largely been neutralized. The real issue is what types of firms are best suited to the investment opportunities, and how this might impact the structure of the industry. 

Unlike the barbell shape of the hedge fund industry, I’d posit that the venture industry, at scale, looks more like a normal probability distribution. If there is little operational leverage in scale, then it is the nature of the firms, their capabilities and their risk-taking that governs the shape of the industry:

• Micro VC: As with hedge funds, I expect there to be a bubbling cauldron of seed stage firms, small and nimble that are able to efficiently write smaller first money-in checks and which bring professionalism to the seed stage landscape. These firms, as they do today, will partner with angels to drive “Friends and Family” rounds of financing though may follow on as investments mature. Some Micro VCs will make the jump and morph into the next stage (Life-cycle VC), but others will keep fund size small and focus largely on seed stage investing that stops at the Series A. Most Micro VCs have funds between $10-$75 million. Examples of current Micro VCs include Founder Collective, Metamorphic, Freestyle, SoftTech VC, Floodgate and my firm, IA Ventures.

• Life-cycle VC: These are firms that will often establish an ownership position at the seed stage, but which have the capital to continue financing a start-up into the Series B and C rounds. Sometimes they will first invest in a company at the Series A, but only if is reasonably priced and where they can establish a threshold ownership position. These firms generally have funds between $150-$250 million, and will (and can) increase exposure to a winning investment as they require additional capital for growth. These firms in many way sit in the “sweet spot” of venture investing, small enough to dip down into the seed stage while having the dry powder to reserve heavily and to plow $15-$20 million into a single company if it makes sense. Examples of Life-cycle VCs include True Ventures, Flybridge, Foundry and Union Square Ventures.

• Growth VC: It strains the term to call this stage of financing “venture” investing, as much of the execution risk has been stripped out of the business and all that remains is rapid scaling. These firms are a hybrid of venture and private equity, in that the analysis of what constitutes a winning investment is markedly different than what Micro VCs and most Life-cycle VCs perform. The dollars deployed are much larger and the exit multiples much lower, but the risk profiles are sharply muted relative to the Micro and Life-cycle VC models. Investments at Series C and D stages and beyond can be upwards of $100 million per company, and require fund sizes of $750 million or more. Examples of these firms include IVP, Insight Ventures and Tiger Global.

I expect to see the greatest AUM in Life-cycle VC, with Micro VC and Growth VC being smaller but critical elements of the venture marketplace. Regardless of the poor 10-year returns, the venture capital industry is alive and well, and an essential catalyst of innovation in our country and across the world. Poor performing “zombie” firms will eventually be swept away, but it in no way casts a pall upon the industry. The quest for management fees and venture capital are anathema: those firms which became intoxicated by large AUM got burned and will die a slow death. A healthy and growing body of new, carry-focused funds will rule the day, which is why the Micro VC and Life-cycle segments of the venture landscape are so exciting and hold such promise.

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The Presidential Working Group on Hedge Funds Has Been Reading My Blog! Amen.

So the Presidential Working Group on Hedge Funds has spoken - “no” to new regulation, but a stepped-up focus on accredited investor standards, regulated institutions and fiduciaries. I’ve got to say that these are exactly the themes I’ve been writing about since August, and with greater frequency over the past few months. It’s nice to see that my hiatus from Wall Street has not rendered me completely out-of-touch with my former vocation. I am obviously thrilled with their conclusions and recommendations, and believe they are supportive of continued innovation and the further development of the hedge fund business in the U.S.

Some snippets from today’s New York Times article:

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Instead, the administration, in an agreement it reached with the independent
regulatory agencies, announced that investors, hedge fund companies and their
lenders could adequately take care of themselves by adhering to a set of
nonbinding principles.

The principles, many already being followed by the sharpest investors and
best-run companies, say that investors should not take risks they cannot
tolerate and should carefully evaluate the strategies and management skills of
hedge funds. They also call for funds to make clear and meaningful disclosures
to investors.

********************

The working group rejected any proposal that would give the government the
ability to inspect the books and records of hedge funds or force the funds to
make regular reports about their activities. Both banks and brokerage firms must
adhere to stringent rules that give regulators great leeway in supervising
them.

********************

“Private pools of capital can be an appropriate investment vehicle for more
sophisticated investors,” read one of the main principles that the officials and
agencies agreed upon. “Because these pools can involve complex, illiquid or
opaque investments and investment strategies that are not fully disclosed, the
risk associated with direct investment in these pools are most appropriately
borne by investors with the sophistication to identify, analyze and bear these
risks.”

The report said that the concerns of less sophisticated investors in pension
and retirement vehicles could best be addressed “through sound practices on the
part of the fiduciaries that manage such vehicles.”

********************

“Too often, regulators reach immediately for new laws or rules which can have
the unintended consequence of stifling innovation or smothering markets,” Mr.
Green said. “By instead providing principles and guidelines, the President’s
Working Group has recognized the importance of flexibility and efficiency in a
healthy marketplace.”

Amen.

And for your reference, some links to previous posts on the issue of hedge fund regulation:

• 02/12/2006: The G-7 on Hedge Fund Risk: Politics Abound, But Getting the Right Answers



• 01/30/2007: “Implicit” Hedge Fund Regulation: Moving in the Right Direction



• 01/09/2007: Who Says Hedge Funds Aren’t Regulated?



• 10/26/2006: More Mistaken Thoguhts about Hedge Funds - A European Perspective



• 07/27/2006: Do Hedge Funds Give Rise to Externalities?



• 07/16/2006: Much Ado About Nothing - the Hedge Fund Regulation Debate

One of my readers, Mark McQueen, who writes the Wellington Financial blog in Canada, put up a post himself on the results of the task force and the fact that the regulatory environment in Canada appears to be moving in the opposite direction of the U.S.:

This decision, which is against the wishes of the SEC, flies in the face of
the draft rules released earlier
this week in Canada by the Canadian Securities
Administrators. And they appear to be aimed directly at the Canadian hedge
fund community, according to the Globe, and is greatly
influenced by what the Portus fellows
pulled-off:

“Portus operated in the exempt market, selling products to wealthy investors,
an area that would be more closely regulated under the new standards. Its
managers would also now have to be registered under the proposed new rules. And
the disclosure of referral fees was a particular concern with Portus, where
investors complained that they hadn’t known their advisers had received large
fees for steering them into Portus products.”

And in the wake of this regulatory dichotomy, Mark asks the following question:

But what about the Canadian office of a U.S.-based hedge fund manager that
taps the Canadian market for limited partner capital? Should Fortress (FIG-NYSE), for example, not be subject to
regulation but a Toronto-based Amaranth II would be?

Good question, Mark. What I will tell you is that fair or not, no U.S.-based hedge fund will be spending much time setting up offices or raising capital in Canada if this would cause them to be ensnared in a web of local regulations. It’s just not worth it. So what will happen? Canada, because of its regulatory regime, will lose out on the innovation and talent fueled by the U.S. hedge fund community. And this would be a shame. But certainly not unusual - Governments enact rules and regulations all the time that have unintended adverse consequences, and this will just be one more to add to the pile (see Continental Europe - their pile is absolutely gigantic!). It remains to be seen whether such regulatory asymmetry will actually come to pass, but if it does, the big loser will be Canadian investors - not U.S. hedge funds. They’ll figure out other places to raise a few bucks.

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“Best Ideas” Funds: Repackaging an Old Idea, But at What Cost to Alpha?

When I read a story in yesterday’s Financial Times about “Best-ideas” hedge funds, I had to chuckle. Needless to say, this “new” idea is anything but. Top institutional investors have long been able to structure “best ideas” side-pockets or managed accounts with their managers to gain additional exposure to a handful of top positions. And sometimes these arrangements come along with higher performance fees, but perhaps reduced management fees (as they are really extensions of positions already being “managed” in the main fund). It was a way for a manager to leverage a high-conviction idea in a manner that didn’t go against either the letter or spirit of its fund documents, while providing a super-sophisticated, risk-tolerant investor the opportunity for incremental alpha. And for that, they’re willing to pay. This all makes a lot of sense, and has made sense for a long, long time.

But what of these new best-ideas funds? It seems to me that they open a Pandora’s Box of potential problems, substantially out-of-line with the messaging around the benefits of such funds. I can think of a few off the top of my head:

Inherent conflict with the native fund. If a best-ideas fund is an offshoot of an existing fund (call it the “native fund”), and if it is going to have sufficient mass to warrant it being a separate fund, won’t a substantial scaling up of a subset of the native fund’s positions dampen returns for the native fund? Won’t this make it harder for the native fund to exit its positions in the shares held by the best ideas fund, either because:

1. the SEC will aggregate the holdings of the native and best ideas funds for ownership purposes, potentially subjecting the native fund to onerous restrictions it would have avoided absent the best ideas fund; or



2. the sheer size of the combined funds positions is large relative to daily average trading volume, potentially adversely imacting returns for both funds? Are share sales allocated pro rata by capital? First in first out? It is a hard question.

Now, to be fair, there are situations where a native fund/best ideas fund could benefit the owners of both. Consider David Tepper and Appaloosa with Delphi (see earlier post): he effectively called in $2 billion of capital from existing investors in order to have a stronger hand during the Delphi reorganization. This could have been done as part of a best ideas fund or a side pocket, which would have had beneficial effects for both native fund and best idea fund owners. But I see these types of situations as being more the exception than the rule. But that’s just my perception.

Dilution of returns. One of the great things about best ideas in side pockets or in managed accounts is that they augment a strategy, they aren’t in and of themselves a strategy. If a fund raises money explicitly for this purpose, you know what will happen - they will get too big in these high-value, high-alpha potential positions and get in their own way, squashing alpha generation. And this is bad. Part of the phenomenon of the institutionalization of the hedge fund business is that large firms are now building less volatile, less high-returning (and less alpha generating) portfolios, increasingly looking like virtual fund-of-funds from a risk/return perspective. Why? Because this is what a lot of institutions want who simply are seeking exposure to the hedge fund asset class. Nothing too racy, nothing to complicated. Then there are those more sophisticated institutions who are frustrated by this dumbing-down of the business, actively pursuing alpha through willingess to accept incremental volatility and concentration risk. These are for whom best ideas accounts are designed. By “fundifying” the best ideas strategy, however, you can be sure that alpha will be drained away from these ideas in short order.

I do want to raise the caveat that “concentrated” funds are not subject to the same issues I’ve raised above. If a manager establishes a fund, with the charter of holding 5-10 positions, that’s great. Investors know what they’re getting. The manager knows what their job is. All is clear. This is very different than having a fund, setting up another fund where a subset of the original fund’s positions are cherry-picked and sized up in the new fund. This is what leads to dilution of returns and potential conflicts of interest. This stinks.

Yet another way to generate fees. Readers of my blog know I am a supporter of, an investor in and a former employee of hedge funds. But I am deeply concerned by this development, as it smacks of packaging/re-branding and not of true value creation. In fact, I’d argue that this will ultimately be value destroying, particularly for those who have participated in best ideas strategies before but who now will simply be riders on a much-more-crowded bus. Some strategies are just not designed to get big, i.e., certain ultra-high frequency statistical arbitrage strategies. If you could be happy running $50 million and generating super-attractive risk-adjusted returns all would be fine, but no, you want to build a hedge fund of scale, create a legacy, etc., which causes you to alter your strategy and tinker with your models in ways that undermine the original (and successful) incarnation. And this is a shame. Does this sound like the best ideas fund concept? I think so.

And this is, I’m afraid, the likely path of the best ideas hedge funds, which seem like a logical new product but will eventually collapse under its own weight. Time will tell but I am highly cynical. Sorry.

Conclusion

Given the rush of assets into alternative assets in general and hedge funds in particular, it is very seductive to develop new ways to gather more assets to build scale and, yes, generate incremental money for the principals when it may not make long-term financial sense for the LPs. I am not suggesting that this is some kind of conscious conspiracy on the part of fund managers to separate institutions from their money for “new” ideas: in fact, I am 100% certain that many institutions are approaching managers with precisely this best ideas fund idea. What I am suggesting is that a disciplined, long-term oriented manager might want to “just say no.” Why risk pissing off existing LPs, frustrating new LPs and potentially damaging performance in the name of a new asset gathering exercise? I don’t know why. Money talks. But sometimes you just have to talk back.

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Hedge Fund Activism: Returns Follow Conviction

Mark Hulbert penned an interesting article in today’s New York Times concerning a recent study of stock price performance in the face of hedge fund activism (defined as owning 5% or more of a company’s shares). The conclusion: shares in companies that are the targets of such shareholder activisim outperform the market both before and after the hedge fund’s position is publicly disclosed, and that ownership is typically for a longer time period than one might expect.

The authors examined nearly 900 instances from 2001 through 2005 of
what they call hedge fund activism. The professors compiled their
database in large part from the reports that hedge funds must file with
the Securities and Exchange Commission whenever they acquire at least 5
percent of a company’s outstanding shares and intend to get involved in
running the company.

********************

The professors found that the stock of the average company singled out
by a hedge fund outperformed the overall market by 7 percentage points
over a four-week period: the two weeks before and the two weeks after
the hedge fund’s public acknowledgment that it was aiming at the
company.

********************

In the year after that initial month of market-beating performance, the
average target company’s stock kept pace with the overall market. And
over the subsequent two years, the professors also found, the operating
performance of the target companies improved markedly.

********************

The professors also examined whether hedge funds that try to change
corporate behavior typically focus more on the short term or the long
term. They found that in nearly half the cases they studied, the hedge
fund still owned a large stake in the target company in October 2006.
And in those cases when the hedge fund had sold its stake, the average
holding period was close to one year. From this evidence, the
professors conclude that “activist hedge funds are not excessively
short term in focus.”

“Hedge funds provide an example of
effective shareholder activism,” Professor Brav says. He noted that
“when other institutional investors engage in activism — such as
pension funds or mutual funds — they typically have not been effective
in improving firm performance.”

I find the study’s conclusions to be intuitive for one principal reason: conviction. Activist investing is a much harder, complex and time-consuming road to returns than simply establishing what one perceives to be an undervalued or momentum-fueled long position. I had written about some of the features of this type on investment when discussing David Tepper and Appaloosa, often requiring skills such as law and keen strategic thinking to augment stock-picking talent. So if a hedge fund is going to pursue this road to returns, it had better have strong conviction, and it generally does as evidenced by a position of significant scale. Why does the stock run up two weeks prior to disclosure? Because of the hedge fund scaling into its long position. Why does the stock continue to outperform two weeks after disclosure? Because other investors want to ride on the coattails of conviction, research and heavy-lifing (read: pursuing the activist agenda) of the activist hedge fund. But the really interesting feature is that superior performance appears to be sustained beyond a year after position establishment, and that the hedge funds still own substantial stakes after one year.

Think of a long-term activist investment strategy as being aking to much of what has happened in the world of statistical arbitrage. Initial holding periods and attractive returns in stat arb strategies were available in milliseconds,  almost akin to a riskless market-making strategy. Then as others got wise to this game capital flowed in, pushing returns at the short-end of the time spectrum to zero. So what did managers do? Extend holding periods, designing models with longer-term signals that offered opportunities for alpha but also required more capital and entailed more risk. The same type of evolution has taken place in people-driven (as opposed to model-driven) strategies. The quick money to be made on early information is a much harder game than it used to be. So what many funds have done is to trade not on pure information but on skill and strategy, ergo the rise of the activist hedge funds. But this takes a lot of capital, a lot of managerial resources and a lot of time. But as the study shows, this can result in outsized rewards. But it is a tough, tough game. And make no mistake, the game is getting tougher every day.

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The G-7 on Hedge Fund Risk: Politics Abound, But Getting the Right Answers

There was much speculation as to what would come out of the G-7 meetings in Essen, Germany concerning hedge fund regulation. Most industry observers with a sense of history would have expected the obvious: a lot of saber-rattling with little concrete results. And you know what - they were right. But that’s ok. The good news is that the stuff the G-7 should be focused on - systemic risks, an emphasis on better understanding regulated institutions like banks and self-regulation among hedge funds - is the stuff they are focusing on. Funny, that’s the stuff I’ve been focusing on for some time:

• 01/30/2007: “Implicit” Hedge Fund Regulation: Moving in the Right Direction



• 01/09/2007: Who Says Hedge Funds Aren’t Regulated?



• 07/16/2006: Much Ado About Nothing - The Hedge Fund Regulation Debate

Be that as it may, the desire of Germany to be more overbearing (as usual) in their regulatory regime was (at least temporarily) beaten back, though they hope to push through some concrete measures concerning transparency at next year’s G-7 summit.

From the Financial Times:

********************

Although the global financial system has been relative free of
financial crises in recent years, European central bankers and finance
ministers in particular have expressed concern about hidden “systemic”
risks that may have been created by hedge funds, particularly given the
opaqueness and complexity of many deals. The US has also stressed the
importance of investor protection.

The UK and US were wary of any
initiative that could have created regulatory hurdles for hedge funds
and the German presidency had tailored its proposal accordingly,
scaling back its original ambition to agree on a set of instruments to
monitor hedge funds by the end of the year.

********************

Speaking after the Essen summit, Jean-Claude Trichet, president of the
European Central Bank, said that there had been “a lot of reflection in
the industry” but there had not yet been agreement on standards and
codes that would form a system of self-assessment. “I’m sure that the
industry will crystallise on an appropriate concept,” he said.

********************

Axel Weber, president of Germany’s Bundesbank, said that “vigilant
means that we are anything other than complacent”. Rodrigo Rato,
managing director of the International Monetary Fund, said that the
evolution of recent financial markets had helped spread risk “but there
are maybe new vulnerabilities possible”.

I don’t know if I’ve ever heard JC Trichet so rational, conciliatory and laid back. Unfortunately, I can’t say the same thing about Mr. Weber; his comments were predictably goofy, politically-motivated and vacuous. He was engaging in the chest-thumping that characterizes one whose power is sharply limited by objective reality. Sorry, Axel.  But you’re just not driving the bus. Thankfully.

I made a few comments in a Bloomberg article shortly after the G-7 meeting broke up:

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“We’re seeing a maturation in the way governments are
viewing hedge-fund risk,” said New York-based Roger Ehrenberg,
former head of DB Advisors LLC, a subsidiary of Deutsche Bank AG
that managed hedge funds.         

“Hedge-fund managers recognize that they’ve done a poor job
at public relations,” Ehrenberg also said. “They recognize that
they have to cooperate given the size to which the industry has
grown.”

********************

Turns out Hank Paulson also has a similar view (from the FT article):

“Whenever something is growing as quickly as this (the hedge fund industry), it bears looking at,” said Hank Paulson, US treasury secretary.

Hey, Hank and I are rational guys. Hedge funds have grown to the point where you just can’t deny their importance or their impact in the global financial landscape, and they need to be better understood. The SEC has been working on better understanding hedge funds for at least 5 years, since they walked into Deutsche Bank (and several bulge bracket firms and their prime brokerage units) and interviewed a bunch of us on an exploratory mission. This was a healthy and smart thing to do in light of the obvious expansion in industry AUM and the growing institutionalization of the business that was going to cause AUM to rocket for the foreseeable future. The FSA intelligently underwent a similar exercise.

It is this type of deep understanding that makes regulators effective and less apt to make knee-jerk, destructive decisions laden with unintended consequences. The results of the G-7 deliberations directly reflected this base of knowledge that exists today, and are now focused on those areas where more data needs to be collected and more learning needs to occur. Let’s hope these positive trends in the regulatory environment persist and that the G-7 membership is able to keep the regulatory-happy German politicos at bay. For the good of the hedge fund industry and the global financial system.
         

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