The Elephant in the Room: Hedge Funds and Mutual Funds
When mutual funds and hedge funds cough, venture capital catches a cold.
Between them, U.S. mutual and hedge fund managers have approximately $19 trillion of assets under management. Venture funds, in contrast, generally raise $20-40 billion in a given year, less than 1% of that total. Following an upsurge in private-market investment by the two fund segments, it is not surprising that they have had a growing impact on the VC space. What began with a trickle of funds investing in a few pre-IPO favorites has over the past three years evolved into a flood of more than sixty managers who have participated in or led mega-rounds.
We believe growing mutual and hedge fund involvement has been one of the key drivers for the rise in the number of so-called unicorns—private firms with $1 billion-plus valuations. Not a day goes by where we don’t see some mention of these pre-IPO behemoths in the media or at business and finance websites. The Wall Street Journal even created a startup stock ticker to track changes in mutual funds’ estimates of private share values. More than likely, the firms’ executives and board members had not expected that behind-the-scenes discussions would become fodder for the masses.
That said, the tide has recently shifted. Over the past six months, negative sentiment surrounding valuations, as well as more broad-based concerns about the technology industry, have led many pundits to prophesize the demise of some of the unicorns, and in some cases, the sector more broadly. Not coincidentally, mutual and hedge fund VC-related investment activity has fallen sharply, hitting a three-year low in the first quarter.
So, what happens next? To find out the answer, we recently spoke with over 40 mutual and hedge fund managers, who represent a sizeable share of those who have invested in the venture capital space. Among our findings:
- There are three reasons why managers have invested in pre-IPO firms: gaining access to fast-growing companies that are staying private longer than in the past; securing a toe-hold position for an eventual IPO; and gleaning general technology insights that could be helpful in researching publicly-listed counterparts.
- Private investments represent a small percentage of the funds’ assets under management—in general, less than 1%.
- Most of those polled only invested in a handful of companies that they loved.
- While many investors are experiencing valuation remorse amid recent markdowns and other negative developments, they remain optimistic that the private-market firms they own can become the next generation of technology companies in the world and can grow through their previous values.
- Six investors among those we spoke with have accounted for the bulk of crossover venture activity over the last few years. We estimate their invested capital represents a double-digit percentage share of the market. In our view, their size and leadership position in the sector has afforded them outsized influence.
- Mutual and hedge funds have scaled back their interest, but most are still allocating funds and actively seeking new investments in the private arena. We believe they are not going away but are only temporarily dialing back the pace and magnitude of their activities. Only one investor was discontinuing further participation.
In light of the above and other proprietary research, we believe roughly half of U.S. mutual and hedge funds that invest in the VC market may call time on their participation over the next twelve months. That said, there are almost thirty such funds that will continue investing in pre-IPO companies. Even among those crossover investors who are scaling back, it appears more a matter of them being patient rather than losing interest, especially where they have dedicated pools of capital available for this type of investment.
Overall, it seems clear that those who invest in private markets accept that valuations are higher than for publicly-listed peers. Historically, the reverse has been true, reflecting an illiquidity discount. In fact, we can’t remember a time that private market valuations have been so disconnected from comparable public measures for so long. According to Goldman Sachs, valuations in some sectors are 1.5x public-market counterparts, above the range that prevailed from 2012 to the mid-2015 lift-off.
If history is any guide, this valuation imbalance is unsustainable. Another concern is the fact that some of those investors we spoke with who dabble in private markets said they might not buy into the public offering of pre-IPO companies in which they had invested (assuming they do come to market). Depending on how widespread this view is, it could mean that the long awaited rebound in demand for small cap technology shares and IPOs is not yet at hand, further diminishing prospects for private-sector firms seeking a public exit.
Source: Renaissance Capital
In fact, the backlog of private businesses looking to go public is already significant—and growing. According to CB Insights, there are currently more than 530 VC-backed companies in the IPO pipeline, waiting for market conditions to improve. While many are well funded and likely able to sustain high cash burn rates for some period of time, the risks increase as each day passes.
Making matters worse is the fact that hedge and mutual funds have less capital to invest than previously. The former, in particular, has seen a wave of redemptions following a span of subpar returns, especially over the past 15 months. Citing forecasts from JP Morgan, Fortune reports that hedge funds will experience total outflows of at least $25 billion this year. A poor IPO market and a reappraisal of illiquidity and other risks amid a tighter monetary policy environment suggests that many managers will be extra careful about how they allocate the assets they have left.
Most fund managers we spoke with believe the software IPO market, in particular, could benefit from the likes of major players like Microsoft, Oracle, SAP and IBM acquiring smaller public companies, potentially creating pockets of demand that could be filled by private firms coming to market. That said, until IPO returns are seen as more attractive than those that have been garnered from investing in secondary issues, institutions have little incentive to step out of the publicly-traded safe zone.
Whether or not the appetite for initial public offerings returns, the private market may also be confronted with another hurdle. Some of the investment managers we spoke with said that they are getting tired of the scrutiny they were receiving from auditors who demand time-intensive and more frequent—quarterly or even monthly, in some cases—valuation processes for each private investment they hold. A few also speculated that regulations may come to pass that limit mutual funds from holding illiquid investments.
Regardless, whatever hedge funds and mutual funds decide to do, the venture ecosystem will be watching these elephants in the room very closely.
 Bellini, Heather, Heath Terry, Jesse Hulsing, and Gabriela Borges. Views from the Valley – Public vs. Private Multiples, and More Unicorn M&A. Goldman Sachs. 2016.