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Hedge Funds May Be Venture Capital Game Changers

Blending venture and hedge funds offers a more promising way to tap recovery, as the Facebook IPO shows.

It’s been a struggle of late for large institutional asset owners to invest in venture capital. Although some university foundations and endowments did well investing with key Silicon Valley–based venture capital firms during the dot-com boom of the late 1990s, over the past decade venture capital has not seen the same inflows or interest from large institutional investors as, say, the hedge fund industry has. Some of these investors question the risk profile of venture capital, their ability to put significant assets to work and their ability to get access to top-tier mangers. As a result, commitments from this investor base remain limited.

Large U.S. pension plans allocated an average of 8.9 percent of their assets to buyout funds, a small subsection of which is believed to be venture capital, compared with 7.4 percent for hedge funds. (Assets dedicated to venture capital itself aren’t broken out.) The five funds that make up the $122 billion New York City pension system have exited their venture capital portfolio, which was started in the late 1990s, after deciding that the asset class was not for them. That there is little reliable data on venture capital investing alone demonstrates how venture capital has yet to be firmly established by institutional asset owners as a separate, and sizable, asset class. 

At the same time, however, many investors believe that the best hope for any U.S. economic turnaround lies in new arenas such as clean technology, social networking, online media and financial technology. It is not a coincidence that overall inflows into venture capital have increased by 12 percent through the second quarter of 2012, compared with this time last year, according to data from the National Venture Capital Association. And more inflows might follow, if an option that offers the best of hedge fund and venture capital investment approaches draws fresh interest — that is, funds that include both private venture capital investing with public market, long-short equity hedge fund investing. 

A San Francisco–based pioneer in this approach, Crosslink Capital offers pure venture capital funds, pure hedge funds and venture capital–hedge fund hybrid funds that invest in both the public and private equity markets. The $1.8 billion firm, co-founded by former Intel executive Michael Stark in 1999, just closed its latest hybrid fund, Crossover Fund VI, after raising some $320 million in capital for it. “What we really understand as a firm is growth companies,” and people who are changing markets, says Stark. Now, he says, feels like a resurgent moment for growth, which has been out of favor for much of the past decade. In particular, today, Crosslink is considering the digital, social media and financial technology sectors, relying on its experience and vast network of relationships and contacts to source deals.

Those relationships Crosslink has in the private markets and the research it does on the public side produce synergy. The custom relationship management business, which was a very successful hedge fund investment for Crosslink, started as a potential venture opportunity. But when stopped taking venture capital, Crosslink waited until it went public to take a position. At the same time, an investment in the computer giant Apple and the realization that its music platform, iTunes, was likely to transform the way people consume music, led to a search on the venture side of the business for an online Internet radio product and an investment in Pandora — the Internet radio station — on which Crosslink made back 20 times its original investment.

A challenge for any firm like this is how to manage the conflict of interest that can arise when a firm invests in both the public and private markets. Crosslink typically takes a board seat in its venture portfolio firms, and its bylaws prevent it from investing in the public equity of any firm where it has a board seat. As it happens, the majority of its hedge fund positions are in large-cap stocks, which are mostly removed from the venture universe. To underscore its commitment to investors in both markets, Stark stresses that his firm places a premium on integrity and ethics.

While Crosslink’s business model is somewhat unique, it is certainly not the only hedge fund firm to appreciate the public and private investment opportunities in potentially game-changing technology firms. Tiger Global Management, the $6 billion, New York–based technology-focused hedge fund founded by Chase Colman, created a separate entity, Tiger Global FB Partners, and invested in Facebook before the social networking firm went public. The San Francisco–based $2.7 hedge fund firm Valiant Capital Management also took a pre-IPO stake in Facebook.

Then came the IPO in May, and its high-profile problems and swoon in share price. According to the most recent public filings, Valiant no longer has an equity stake in the company, while Tiger Global continues to hold a position. Though Facebook recently hit 1 billion active users, would-be investors and analysts alike continue to question its revenue potential. But private investors in Facebook did just fine, or at least early stage buyers did, demonstrating why investors in this sector can benefit from having both the public and private market options available to them.

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