VC#9: Hedge funds in VC - all rules can be broken
something about rules and games etc. goes here....
Disclaimer:
All content, all names, characters, and incidents portrayed in this post are all fictitious. No identification with actual persons (living or deceased), companies, places, buildings, and products is intended or should be inferred. Any similarities with actual persons or companies, places, buildings, and products is purely coincidental. We do not intend to hurt the sentiments of any individual, company, community, sect or religion.
Last weekend was spent at a virtual GP conference. I have always wondered what the breakout rooms in Zoom were all about. I finally found out. It was nice that the organizers took the time to understand the personalities and the investment styles of the participants and put them in touch with people who were opposite to them. Learnt a lot.
One of the things that kept coming up was the approach of Tiger, Softbank and other “irrational players”. Let me know if any of these quotes feel familiar:
“Lost my deal to Tiger. 6 months of work down the drain. I am in sell only mode. Let the hedgies buy silly.”
“They are not even doing Due Diligence. WTF man”.
“These Hedgies think any deal at any price is a good deal”.
“&^%&^% hedge funds. Hijacked my deal by giving a higher price”.
“Softbank valuations are evidently anchored to a fiction only they understand”.
If you are an active investor in high growth tech businesses, there is a very high chance that you have had a conversation like this sometime in the past 36 months or so. Or rolled your eyes at some guy lamenting the death of critical thinking and sane valuations (myself included).
Have you heard the old chestnut about old people impeding progress - that’s kind of how I feel these days.
Now, let’s leave Softbank out of this - I don’t think even they have a clue as to what their strategy is doing. Let’s instead take Tiger as a representative example1 and see exactly what is going on in the hedge fund world…
1. Rules of Private Equity, as I know them
Be respectful of elders (not really, only joking).
Pay attention to fundamentals.
Work on deeply understanding the business.
Diligence to a no-surprises state.
Create a structure to address gaps in performance and align incentives - price risk and uncertainty.
Get deeply involved post-investment. Shape and guide the company to an exit.
Deploy capital in a sane manner. Most of institutional capital is pension funds - retiree money. Don’t throw it away - it is life’s earnings for people, extremely hard earned money.
If you can, avoid profiting at someone else’s expense.
Maintain relationships. You never know what/who comes back to help later.
And this framework is something that informs every decision. As an example, I was among the first PE managers to invest in the Diagnostics market in India. I studied all business models, decided to invest in one which had a better dynamic, created a profit sharing structure to bridge a valuation gap, created entirely new products that effectively reshaped the market and then went on to work for the company in a detour off private markets. Another colleague of mine went on to become the CEO of one of his portfolio companies. All of this is possible only when you are deeply involved and acting as stewards of capital. You are involved because you want to make sure there is no loss of capital (as much as you can help it).
It seems, this is the old way of doing things.
2. Key Tenets of Tiger-ing
Ask any 10 VCs for their thoughts on Hedge Funds and most of them will react with a mix of dismissiveness and disgust2. They’ll say that hedge funds are drastically overpricing rounds, not doing enough diligence on their investments, or otherwise breaking the spoken & unspoken “rules” of PE (see above).
Tiger has a well documented record-breaking deal pace & aggressive style. From an outsider’s perspective, Tiger’s investment strategy can be roughly summed up as this:
Pay high prices relative to historical norms and/or competitors.
Be very fast in pre-empting good founders and issuing term sheets.
Rely on others’ diligence.
Have minimal involvement post investment.
DEPLOY DEPLOY DEPLOY!!
So what gives?
Are Tiger & other hedge funds3 the proverbial Greater Fools? Are they bringing a fast moving bull market approach to the wood paneled and leather lined boardroom? Are they streetfighters in a championship bout? Are they smoking/drinking something really, really good?
Probably not.
What we are seeing is the emergence of a Velocity-focused Strategy. At least in the Venture/Growth4 space, this fast deployment, maneuver warfare approach is building an entirely new flywheel5 that is offering better value to founders while generating better returns than their competitors.
Let’s take a moment to coin a term to describe this from a founder point of view. The Tiger investment playbook is faster, cheaper (no / low diligence, and cheaper in terms of time) and better (no board seats, low operational interference) for founders in many ways. Let’s call it Founder Friendly Capital (FFC, hold onto this thought, will come into play later).
3. Streetfighter vs Prizefighter
I will digress for a moment here. We just laid down two set of rules. One is a iron fist couched in a leather glove, and no hitting below the waist. Other is about poking your opponent in the eye while holding him in a headlock while kicking him in the nuts. One of these is a prizefighter. The other one is a street brawler.
Even when these two are competing in the same ring, they are playing very different games. VCs may lament the quality of work that Tiger does on its deals, or their lack of diligence or tendency to outbid folks. And while others are still griping, Tiger raised one of the largest VC funds on the planet and is delivering north of 25% IRR to its LPs6.
At the heart of it, the VC/PE Fund is a professional service offering. It provides money management services to its LPs and acts as a source of capital to the founders. In Econ 101, we learn that the duty of the management is to maximize shareholder returns. To draw it all out:
So, key takeaway? The Fund Manager has really only two constituents to answer to - the LPs and the Founders7. Between these two, there are as many ways of maximizing fees and carry8 as there are private markets professionals. You must keep both happy in order to survive. Those that don’t are eliminated - because they can’t raise more money or because they can’t deploy their capital. Every other rule is a myth. You are free to maximize your. fee and carry via any means your constituents will accept.
Once we accept this simplification, there are multiple ways to play the game. The best strategies and tactics evolve over time. As an example, I spent most of my career in a $500mn mid-market fund. Mid market funds don’t exist today for the most part because the likes of Blackstone will write smaller cheques and the likes of Sequoia will happily write bigger cheques to not lose the “deal”.
There is no right or wrong way anymore. Tiger’s style then can be described with just two sentences.
Maximum Velocity
Founder Friendly Capital.
That’s it.
4. Maximum Velocity
When I started working at CX - there was no hurry to deploy the capital. We had a $500mn fund, we had 5 years which to invest it in and we were going to do the best deals we could to maximize the IRR/MoIC9. That approach is the time honoured one10.
Tiger on the other hand is going to deploy as much as it can at let’s say an 18-20% IRR11.
And that is insane. Most funds think about investing speed in terms of deployment schedules12, i.e. “how long will I take to deploy the capital I have raised?” Usually, this deployment period is between 2-4 years, and fund managers do their best to invest along this timeline. I have seen people pass on deals simply because they were ahead on the schedule and they wanted to see what deals came next year.
Now, you may ask - is Tiger onto something? As it turns out, yes.
Here is an equation for you to consider13:
Terminal Incremental MoIC X (1/years of deployment) X Fund Size
=
Net Capital Gains / Year.
Let me give an example. Let’s take a hypothetical $500mn fund. Now, if we are hoping to generate a blended MoIC of 3x and we took 10 years to deploy and recover it, here is what the returns look like:
(3-1)x Incremental MoIC X 0.1 (10 years) X $500mn
=
$100mn Net Annual Cap Gains.
Nothing to sneeze at. However, let’s assume that the fund generated $650mn in total returns since 2009. As of 2021, the equation looks like this -
(1.3-1)x Incremental MoIC X (1/13) X $500mn
=
$11mn Net Annual Cap Gains.
Ouch.
Now, instead of these 10-12 year cycles, let’s say that we deployed and returned capital as fast as we could (let’s say 5 years) even if our incremental returns were only 2x. Here is what that looks like
(2-1)x Incremental MoIC X (1/5) X $500mn
=
$100mn Net Annual Cap Gains.
So, we deployed and returned capital faster, and even though we made only 2x, we generated the same net annual cap gains as investing for 10 years but slowly. And if your fund has the right to plow in profits for fresh investments, you can keep churning this capital for fatter and fatter carry.
And this is pretty much what Tiger is doing. They have dialed the velocity up to 11.
Now, not everyone can do this. You need two key components to dial things up to 11.
LPs who are comfortable with this sort of approach: Not every LP wants things to go at breakneck speeds. All other things being equal - higher velocity means compromises on discipline. The LP who will willingly sign up for a strategy that will result in lower MoIC with higher risk and therefore very likely lower IRR does not exist. However, unlike a typical fund where the GP stake is ~1-2% of the total fund corpus, Tiger’s own team is its largest LP. So, they can pretty much show that their risky bets will likely hurt them the most and so LPs are assured in a big way14.
A team that can handle the breakneck Velocity: There is a saying in the VC world - “venture capital firms don’t scale”. There is a lot more to an investment beyond just writing a cheque. Diligence has to be done, terms have to be agreed upon, documentation has to be airtight, post investment monitoring and interventions are almost 70% of the work. All this needs a team. A large one. Realistically, one team member cannot handle more than 4-5 investments without letting things slip15. Now, Tiger has ~25 people across their public and private funds. To put this in context, that’s about a third of what firms like A16Z and Sequoia have. So, in order to get past the scaling barrier, Tiger must make a product that allows for scaling.
5. Founder Friendly Capital (FFC)
So, we’ve all heard of Product-Market Fit right? Think of the PE/VC industry in this context. Each fund has a document called the “Product Program”. Startups build and sell products to their customers. Same way, PE/VC funds sell their product to LPs and Founders. As far as the Founder is concerned, the VC is no different from a moneylender. Money is a commodity. So why does a founder sell his equity to a VC? Here is the Mount Rushmore guy of VC explaining it:
A fund’s product consists of everything that affects a Founder & business before, during, and after an investment process that stems from the fund - often with long term effects. Today, a typical venture/growth fund’s product looks something like this:
A 4-6 week diligence process. This will include, but will not be limited to multiple calls with founders and key employees, vetting with customers and vendors, a deep, root-canal like background check on founders, a large and ever-growing list of data requests, etc.
A valuation that provides the fund with a strong base case return and an option on wild outperformance.
The signaling / branding provided by the fund’s reputation.
A board member (or multiple board members) to help provide guidance.
Other misc. investor value-add — access to network, recruiting help, in-house operating teams, etc.
Problem is - founders are getting wise to a few facts. The board member is really there to protect the fund’s interest. The networks etc almost never materialize. The Fund’s resources (like ops teams) are again working for the fund and not necessarily for the founder. The core pitch of most venture/growth products is built around the various areas of value-add that the fund will provide a startup, when in practice the funds provide little (if not zero) actual value.
Tiger’s strategy for disruption: VCs are rarely if ever useful, so the best I can do is to offer cheaper capital (less dilution via higher price), a quick process and a commitment that I will stay out of their way post investment. If you want value add, I will provide you access to the best management consultants I can (in this case, Bain).
Now, this style isn’t for everyone. Not every founder wants this. But if you’re a founder who already has great investors on your cap table, has little use for more “value add”, and are looking to minimize dilution, wouldn’t FFC be an attractive way to raise the monies needed?
So, if we were to try and make a flywheel for Tiger, this is what it would look like:
By focusing on the only two constituents and eschewing all else - Tiger has managed to build a value creation engine that turns established wisdom on its head.
6. Other Enablers
Increased predictability of outcomes in the VC/Growth Capital category — Tech business models like SaaS have become much better understood by the investing community in the last 5 years, as have the growth levers for these businesses and the methods for valuing them. With increased predictability comes less need for a large “margin of safety” from LPs. Instead of insisting on a 4-7x MoIC from GPs due to the inherent volatility / unpredictable nature of VC/Growth Capital returns, LPs have increasingly displayed an acceptance of lower MoICs.
Tiger’s Scale is Insane — Tiger has ~$65bn of AUM. Hell, they own about ~$4bn of JD.com stock which alone is larger than most venture firms’ entire AUM. There are natural advantages and competitive distortions that come with this level of scale. For example: a $15-30mn Series B check may be a massive deal to a $500mn fund, but a mere rounding error for Tiger. So Tiger can invest with less work and at a higher price vs. the $500mn fund. The option of investing much larger dollar amounts in a subsequent round is so valuable that Tiger will put up the blind, so to speak.
7. Black Swans
There is a pretty large risk factor to this approach. The Black Swan. Here is a verbatim quote from someone I spoke to while writing this:
“Valuations are divorced from reality because Tiger pays the highest prices. Markets are at unsustainable levels, so when the inevitable crash comes, they will be hit the hardest.”
Sure. It’s not a bad argument.
However, pain is relative. Crashes and recessions do not target individuals, they impact markets and economies. So, on a relative basis, Tiger will still be doing better vis-a-vis the vast majority of funds in any market environment. If a huge crash happens, LPs will likely call it a bad vintage and move on.
To be fair, I am not saying that the traditional approach is useless - it isn’t. Huge franchises like KKR and Blackstone have been built up following those tenets. This is an examination of another strategy, not passing of a value judgement.
And this brings us to a close on this essay. I hope you had as much fun reading it as I had writing it.
Part two of this theme on Debt and Securitization in Tech cos is here.
Housekeeping
As always, I look forward to hearing from you. If you liked this post, pls feel free to share this or subscribe to this newsletter using the links below. While I have been tardy of late, I try to write a 1000-2000 word essay once a week.
Mostly because it has a lot of data available. Other ones like Coatue, Addition (Fixel’s new haunt), Steadview etc are also doing this but data on them is harder to come by. I have nothing against or for Tiger specifically.
Even though Tiger may be propping up some of their best investments.
The more correct term will be Crossover Funds. I’m deliberately leaving Softbank out of this. Theirs is a very different strategy..
Series B to Pre-IPO, for the purposes of this discussion..
What? You thought I’ll let you go without shoving a flywheel under your nose?
Limited Partners - people whose money a PE/VC fund manages.
AKA Supply and Demand.
Multiple of Invested Capital.
Here is a COMPLETELY FICTIONAL STORY: A hypothetical mid-market PE fund had one year when no deals were done. Nothing good was on offer. So, they invested in a telecom business that was in the business of giving foreign sim cards to travellers. Now, anyone with the brain of the size of a pea could see that this business was already obsolete. VoIP calls over skype are going to rule the market. The Investment officer raising this point was called names. ~$30mn was invested. Last time anyone checked, the business is on life support. Moral - deploying capital for the sake of deploying capital is not a game one can play without getting huffed.
I picked up the 18% IRR figure from air. No clue if this is Tiger’s hurdle but this will make me pretty happy…
Which is another way of staggering the incoming flows of cash by the way of capital calls. Also, the IRR clock doesn’t start until the money is called.
Intended for laymen. Yes, I could use fancy IRR formulae but not everyone knows them. Deal with it.
Of Course, you can be a Bill Hwang running a totally proprietary fund like Archegos and blow it all up.
Even though not too long ago, I was handling ~25 investments with one other team member. Needless to say, I did not pay attention to a lot of the portfolio I deemed beyond redemption.