By Hans Swildens and Kathleen Collins
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:
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.
Industry Ventures was formed in 2000 by Hans Swildens to make seed stage investments in start-up technology companies. Shortly after making our first investments the NASDAQ collapsed and the venture business entered a very difficult liquidity period. In 2001, we pivoted the investment focus to purchase shares in venture backed companies in secondary transactions.
Our first secondary investment was the purchase of shares in Speedera Networks from a publicly traded corporation. Hans helped his brother Eric start Speedera Networks with Rich Day and Ajit Gupta (together the "ERA"). Speedera Networks was acquired by Akamai in 2005. Prior to Speedera, Eric and Hans founded Microline Software after Eric wrote various user interface components of Netscape Navigator 1.0 in 1994. Microline was acquired in 1997 by Neuron Data and the combined company rebranded Blaze Software. Blaze went public in 2000 and was subsequently acquired by Fair Isaac.
A few months after buying part of Speedera, the firm acquired the venture capital division of Electronic Data Systems (EDS). During the period of 2002-2004, the firm acquired over $200 million of invested capital from various sellers of venture capital portfolios including Bowman Capital, Enron Broadband Ventures and Infospace. This investment activity was instrumental in the early formation of the secondary market for venture capital investments.
In 2008, we launched our fund of funds effort with the acquisition of Little Hawk Capital Management. We saw inefficiencies and investment outperformance in small venture capital funds. We have subsequently built a portfolio of over twenty small venture capital funds with leading early stage investors. Today we co-invest alongside these funds in their high-growth businesses.
Over the last decade, the firm evolved from being a pioneer of secondary investments into the leading provider of liquidity for the venture capital market. We manage over $2 billion from institutional investors and operate with one of the largest investment teams in the market.×