Should a Venture Capital Fund Act More Like a Hedge Fund? Maximizing Private Equity Returns

Bill Hilliard and Charles Baden-Fuller

Maximizing Private Equity Returns through Public Market Hedging

Bill Hilliard is an active early-stage venture investor. He is also a Visiting Scholar at Lester Center for Entrepreneurship & Innovation at University of California, Berkeley, Haas School of Business

Charles Baden-Fuller is Professor of Strategy and Management at Cass Business School, City University, London, UK. He is also the Editor-in-chief of Long Range Planning - International Journal of Strategic Management

The venture capital industry has remained largely unchanged in its investing style since the industry's birth. We raise risk capital from our limited partners, take positions in pre-public firms, and ride those positions until an eventual exit. Essentially we act like mutual funds, buying low and (hopefully!) selling high.

Is this the optimal trading philosophy for maximizing returns? This paper will make the case that we can increase internal rates of return (IRR's) and cash-on-cash returns by acting more like "Venture Hedge Funds™.[i]" Just like hedge funds, venture funds should identify opportunities to invest in short positions that relate to their long positions so as to increase returns from profitable investments.

Many venture-funded companies fail to provide an adequate return. When a venture partnership finds itself owning stock in a "winning" company, that is precisely when the partnership would like to put more money to work in that investment versus other less promising portfolio holdings. However, the only way that a traditional venture fund (following the mutual fund model) can increase its leverage in proven winners is to wait for the chance to reinvest during subsequent financings. For truly winning companies, or for later-stage companies, subsequent financings may never occur (think Google or EBay). Even if the companies do raise additional funds, investors from previous rounds are typically limited in their subsequent investment amounts based on their pro rata allocation. What is needed is another way to increase a portfolio's relative exposure to investments proven to be successful versus those proven over time to be less successful.

How To Increase Leverage In Proven Winners In Your Portfolio

Venture funds adopting our proposed paradigm can increase returns from proven winners in their portfolio by securing permission from their limited partners to take both long and short positions related to their portfolio investments. Assuming they have structured their terms sheets properly (see below), they are then permitted to increase leverage in their portfolio companies by trading in "stock substitutes". The sequence of events is broadly as follows:

1. Armed with the understanding that a portfolio firm might someday impact the market capitalization of its rivals, investors add information rights to their terms sheets permitting them to utilize any information learned about unrelated third parties derived from their involvement with the portfolio firm.[1]

2. After the portfolio firm begins to thrive, the investor identifies third-party companies adversely affected by the disruptive firm's upcoming innovations. Shortly before the disruptive firm upsets the markets for the identified third-party company(s), the venture fund buys put options (or similar derivatives with equivalent effects) on these rival companies before knowledge of the disrupting firm is widely known or widely appreciated. Put options have as long as a one year duration, which provides ample time for the market to grasp the disruption created by the portfolio company.

3. In due course, the disrupting firm will announce that its product-process and/or market penetration has progressed to the point where its subtractive effects on the future profits of its rivals are obvious to the investing public. As the financial markets integrate this information, the rivals' stock prices will fall speedily. The venture fund is then able to exercise the options (cash-in the derivatives) at a profit.

Case Examples:

We present three of many case examples. Academic researchers Whinston and Collins[ii] monitored the effect of 24 announcements by the airline People's Express in 1984-85 stating the company's intentions to enter new US domestic routes. Each announcement averaged a $3-6 million effect on the market capitalization of incumbents and had little effect on the price of People Express's stock. This suggests that the potential gain from buying put options (or some equivalent derivative) shorting the disrupted rival may be larger than the potential gains from the long investment itself. Even more critically, the gains from the put are earned immediately, whereas the stock appreciation gains from the underlying portfolio investment are delayed until the investor is able to exit. To reinforce the point; investors in People's Express ultimately lost their money in their investment. Nevertheless, they could still have made a profit if they had been able to undertake the hedging financial play.

In the computer industry, in 1987, a Battery Ventures-backed company named Phoenix Technologies announced that it was planning to launch a product that would disrupt Adobe's postscript printer technology. Adobe's stock dropped over 36% over a two-month period. More recently, on February 8, 2005, it was announced that Summit Partners-backed Sybari Software would be purchased by Microsoft. The next day, McAfee (MFE) stock dropped 8.2%, and Symantec (SYMC) dropped 6.4%. The venture investors in each of these cases could have increased their returns dramatically (and immediately) by purchasing, at a suitable time, a put on the stocks of the direct rivals impacted by the actions of their portfolio companies.

In each of the above cases, the investors, as board members of their portfolio firms, had early insight into the eventual disruptive market dynamics. These insights, while not absolutely guaranteed, provided solid opportunities for investors to increase their returns in the underlying companies.

Impact On Portfolio Risk/Return

Because stock prices are volatile, there are risks that the stock price of the disrupted company may move upward due to reasons completely unrelated to the asymmetric information possessed by the venture investors—thereby reducing, or eliminating, the value of the put. However, even without relying on any asymmetric information, the investor has a fair chance of either making or losing money when purchasing puts on the disrupted company. The asymmetric information shades the risk in favor of the venture investor analogously to the way that "card counting" adjusts the odds in blackjack. Moreover, we would estimate that put options priced in transparent markets likely have less inherent risk than our portfolio investment in the disruptive firm itself. In addition, put options have the potential to lower portfolio risk because their return depends far more on the arbitrage, than on the general direction of the market. Therefore, our proposed strategy offers a possibility to multiply returns with arguably the same or lesser risk than before.

The current research cannot yet recommend a specific percentage of our portfolios to allocate toward purchasing puts. However, we would likely approach this issue by calculating the amount of capital allocated toward, but unable to be otherwise invested in, the specific portfolio firm. The combined short and long positions related to a single portfolio investment would never exceed the maximum dollar amounts or percentages that the portfolio would otherwise invest in a long position in that disruptive firm alone. If there is no additional chance to invest "long" in later rounds in a specific, proven winner; then the remaining "dry powder" would be the capital pool under consideration for allocation to investment in derivatives on stock substitutes. Following this logic (even when capping the derivatives investment at 1% of the total venture portfolio for any investment where this situation presents itself) we estimate that this strategy provides an opportunity to increase 10-year portfolio returns by up to 500 basis points on a cash-on-cash basis, and to increase 10-year portfolio IRR's by as much as 2.5 percentage points[iii] for each portfolio company presenting an arbitrage opportunity!

Is It Legal?

Some have expressed concern that our proposed strategies for the investors are not legal. The concerns center on the fact that venture investors are using non-public information to make an additional portfolio gain. We have carefully trawled the insider-trading statutes in the US, and have discussed our example with lawyers and experts. Whilst we are not legal scholars, there is clear U.S. Supreme Court case law and commentary to support our position that the strategy we propose is legal. We particularly refer to United States v. O'Hagan (1997) and to an excellent article in the Stanford Law Review by Ayres and Bankman[iv] who explicitly discuss the legality of trading in stock substitutes.

The applicable United States Statute is Rule 10(b)-5 of the Securities Exchange Act of 1934. This rule states that one cannot "engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security…" However, as far as our case is concerned, to infringe this law, one must either be privy to material, non-public information known to insiders in "Disrupted public company B" or one must have misappropriated material, non-public information about "Disrupted public company B" (unknown to insiders) from an "outsider" who is somehow the owner of such information.

Venture investors in the "disruptive company A" do not fall foul of any of the SEC rules if they take care of the following: (i) they must owe no duty to "disrupted company B" or have any temporary or permanent relationship to B—this means that the investors in A must take care not to be employed by B, or be directors of B, or to have any trading arrangement with B; and (ii), they must likewise make sure that they owe no temporary or permanent duty to any trading partner of B; such as being a director of a major B supplier; and (iii), they must also be sure that company A itself owes no duty to disrupted company B or has any temporary or permanent trading relationship with company B (or is in some way itself prohibited from using the information for its own gain). In other words, "disrupted company B" is an unrelated player in the market competing directly or indirectly with company A. The only other issue of concern, is that investors in A have a duty to company A itself if these investors use A's non-public information. This duty is not necessarily broken just because the investors use this information for personal gain. The key is to ensure that the investors do not misappropriate the information about A.

When venture investors invest in a new company, it is typically the case that they request many investor rights as part of their investment. These investor rights are summarized in the investment's terms sheet. To make sure that the venture investors in A are not deemed to have misappropriated information by later trading on such information learned through their company A-related investment activities, venture investors should simply request explicit permission to use such information as part of their standard terms sheet boilerplate. Sample terms sheet wording used by one of the authors is as follows, but one should always seek legal counsel before drafting specific term sheet language:

"It is understood and agreed that the Investors may learn material non-public information about third-party public and/or private companies who are competitors, suppliers, investors, partners, or customers of the Company as a result of their serving on the Board, or as an investor in the Company. The Company hereby expressly disclaims any and all representations and warranties with respect to such material non-public information, including but not limited to warranties of accuracy and completeness; but grants to Investors unrestricted rights to use such information about third-parties, if any, without notifying the Company."

For more detail on the relevant Supreme Court and SEC rulings, see: "Raising the Returns to Venture Finance" C. Baden-Fuller, P. McNamara, A. Dean and B. Hilliard, Journal of Business Venturing (forthcoming 2005/6), or contact the authors to request a copy. This article will give you a good framework for discussing applications of our strategy with your fund's counsel. It also discusses, in detail, the ethical issues and economic theory underlying our proposed strategy.

The terms sheet and the documents spun out of it fundamentally define the relationship between the company and the investor - the investors' rights, preferences and permissions. By requesting this explicit permission at the time of the investment, you have preserved the opportunity to take advantage of an arbitrage opportunity later, if one presents itself. The time to get such permission is before writing the check.


Clearly most investments won't present arbitrage opportunities as striking as cases above. However, the more successful the investment, the more likely you are to find yourself with a winning company who doesn't need more of your money (while they're knocking the socks off their competitors). Just as many of the terms sheet conditions we all use are drafted to protect profits in special circumstances, this too is a standard clause we should all use increase returns in the right circumstances.

In summary, we believe that we have proposed a new dimension of financial strategy for venture finance. We hope that this article will spur additional discussion, thinking and research on this new venture investment paradigm.

[1] See the "Is it Legal" section for example terms sheet language that might be used for this.

[i] The terms "Venture Hedge Fund™" and "Venture Arbitrage Fund™" are trademarked by, William Hilliard, one of the authors.

[ii] See: Whinston, M. and Collins, S. (1992). Entry and competitive structure in deregulated airline markets: an event study analysis of People Express, RAND Journal of Economics, Vol. 23 (4), pp 445-462.

[iii] Estimates based on the effect seen if one had traded Barnes and Noble options as a result of the actions of KPCB-backed Example was calculated assuming only a single opportunity for this strategy in a typical venture portfolio of 20-25 investments made over a 10-year period. Your mileage may vary.

[iv] See: Ayres, I and J. Bankman (2001) Substitutes for insider trading. Stanford Law Review 54: 235-54.