When deep-pocketed hedge funds made a massive push into venture capital during the pandemic, effectively fueling the tech dealmaking boom, I couldn’t help but wonder how these investors would respond when the market inevitably turned south.
It didn’t take too long for this scenario to play out.
Most hedge funds that were active in venture are now selling startups in the secondary markets, according to a person briefed with ongoing portfolio sales and several secondary investors who were offered these assets. Tiger Global, which has hedge fund roots, has been trying to sell its assets since earlier this year, and at least a couple of other large investors have hired advisers and other consultants to market their assets to secondary buyers, these people say.
This article appeared as part of The Weekend Pitch newsletter. Subscribe to the newsletter here.
Several firms, including Tiger and Coatue, launched into venture by funding startups with traditional 10-year vehicles. But most players in the category were investing out of one large, commingled public and private fund.
That distinction matters a lot in this environment. If a hedge fund is operating out of a commingled vehicle, their LPs can withdraw capital at regular intervals, such as quarterly or annually. That’s what’s happening now, and it’s effectively forcing these asset managers to walk away from their VC strategies in a down market.
In contrast with public stocks that can be sold at any time, hedge funds don’t have a quick mechanism for exiting private investments. If investors ask for their money back, firms with a substantial allocation to private assets will find themselves scrambling for cash. Secondary share sales are providing some relief, but these markets are relatively immature, and sellers have struggled to offload stakes at acceptable prices this year.
Although a person with direct knowledge of one of the secondary processes described hedge funds with significant exposure to VC as “effectively distressed sellers,” he said they are not quite yet desperate to offload many assets at significant discounts.
That may seem contradictory, but it’s possible thanks to some clever financial engineering.
Some hedge funds have found temporary workarounds for the cash-flow problems: They can take a loan against future secondary sales or try to change redemption rules for private companies, essentially instituting a longer lock-up period for their illiquid portfolio. This is buying them time, but not a way out entirely.
For now, it looks like hedge funds’ dizzying foray into venture capital is unlikely to create a mini version of the late ’90s crisis that hit Long-Term Capital Management—a hedge fund that mixed risky bets with extreme leverage. Still, their problems are bad news for the VC ecosystem.
These large players poured an “enormous amount of capital” into late-stage startups in 2020 and 2021, said PitchBook lead VC analyst Kyle Stanford. He explained, however, that without the participation of crossover investors, including hedge funds, large private companies will struggle to raise enough capital to stay afloat.
On the contrary, I am hearing that most hedge funds are likely willing to cut their losses in the venture asset class—at least for now.
The investment pace of most of these firms has already dropped to the lowest levels in years, according to PitchBook data. Four prominent hedge funds—Tiger, D1 Capital Partners, Coatue and Dragoneer Investment Group—collectively invested in 436 VC deals in 2022. That fell to 76 deals this year, an 83% decline, according to PitchBook data.
Unlike VC firms, which are in a “till death do us part” marriage to tech startups, hedge funds tend to be nimble and ruthless about how they invest. They can quickly hire a team for a particular strategy and then later lay off those professionals if the approach no longer seems like an attractive opportunity.
With interest rates at the highest levels in decades, there are many asset classes other than venture—be it public stocks or credit—where these investors are focusing their efforts, provided they have available capital to make new investments. And tech-loving hedge funds may be inclined to invest in future IPOs with the knowledge that money placed on these bets will have shorter lockup windows than startup investments.
Unless interest rates start going down, I expect their participation in venture to keep falling in 2024 and maybe even longer.