Hedge funds beat the market by avoiding it
The IPO market of the 2000s is different from that of the 1990s in one surprising and unexpected way: Successful tech companies are doing their best to stay out of it as long as possible. According to the Quigley report, the result is shocking. In the new tech cycle, more money is accruing to private investors, not public shareholders.
What is causing this sudden shift, and who are the new winners? To answer this question, we need to go back to the economic theory behind the IPO market and analyze changes that are driving different behaviors from some its biggest stakeholders.
In the context of efficient market theory, the IPO market has continued to puzzle economists. If markets are efficient and available information is already priced in, why do so many IPOs remain a hot prospect? Though answers vary, including market failure, externalities, or simple VC/company irrationality, the fact remains that the IPO “pop” on the first day of trading is real and an arbitrage opportunity exists.
Buying IPO shares with the intention of flipping may seem like an easy move for many hedge funds. But the process of unloading shares would drive the price of the offering down, and in an effort to avoid this undesirable outcome underwriters allocate shares to long-term institutional investors who are not looking for short-term profits. Therefore, hedge funds are locked out of the genuinely easy arbitrage opportunity presented by an IPO underpricing.
In light of this challenge, hedge funds have begun opting for the next best alternative: Buy-in to the private company just before the IPO (when it has been substantially de-risked), and then either sell shares in the IPO or hold the stock through the 180 day lock-up period. Chase Coleman’s Tiger Global has been a frontrunner of this strategy, taking private stakes in several high profile late-stage ventures including Palantair, Survey Monkey, Square, Eventbrite, and LinkedIn.
For example, in the 18 months preceding the LinkedIn IPO, Tiger purchased 3.7 million shares at an average price of $16.44 per share. On May 19, 2011, LinkedIn priced its IPO at $45.00 per share, and began trading that day at $83.00 per share, an 84 percent premium. Tiger did not sell shares in the IPO, waiting until a year later to sell 1,620,947 shares in June-July of 2012 at an average price of approximately $107.62 (yielding the fund ~6.5x returns in the process).
Interestingly, none of Tiger’s $60 million initial investment went to LinkedIn. Rather, these shares were purchased in the secondary market, allowing early stage shareholders and management to cash out of their positions early. Presumably these investors needed liquidity, and Tiger provided it in the private market, albeit at a steep discount to the future IPO price.
This need for liquidity is not unique to LinkedIn. The sellers of the Tiger shares were not publicly disclosed. It is highly likely that the sellers were management or an early-round VC being pressured by their LPs to close out a fund. Essentially, Tiger played the role of a pay-day lender, fronting cash to the sellers in return for a future payout at an above market cost of capital.
Why are companies and early stage VC investors allowing hedge funds to take pre-IPO stakes at relatively discounted valuations? Primarily because companies want to stay private longer, but need new and greater sources of capital to do so.
If a company goes public prematurely, VCs are forced to choose between losing potential upside by selling early, or alternatively holding their shares through the lock-up period and hoping the valuation holds. When one missed milestone post-IPO can create a huge collapse in valuation, it is unsurprising that VCs would opt for the former (or delay the IPO altogether). Furthermore, management teams dislike the constant short-term focus on quarterly earnings and high reporting costs that come with being public. As a result, their interests are aligned with VC investors in preventing the premature IPO.
The main cost of going public is therefore best summarized as shareholder volatility, creating a situation in which companies are willing to pay a premium for the stability provided by private capital. In practice, this means companies offer lower valuations to late-stage private investors compared to what could be achieved in public markets. The implication that companies desire to pay extra for private capital out of choice flips the conventional wisdom of the traditional “liquidity premium” on its head. If anything, conventional liquidity premiums should be falling due to the advent of markets like SecondMarket, which lower transaction costs for interested parties such as Tiger.
It should also be noted that Tiger is not the only beneficiary of the inverted liquidity premium. As the benefits (real or perceived) of staying private longer have crystalized among the next wave of tech companies, other sources of capital have followed Tiger’s lead. Of the 17 companies listed in Venture Beat’s review of tech companies that were expected to go public in 2013, 13 of them have received non-VC style funding from hedge funds, private equity funds, or asset managers. Furthermore, only 3 companies from this list have gone public in 2013, 4 including Twitter.
The implication is clear: Any large gaps between late-stage VC and IPO valuations have more to do with companies opting for expensive sources of capital to stay private rather than rising liquidity premiums.
These recent trends also have clear consequences for the IPO market. With hedge funds leading the charge, one can imagine companies pushing for fuller IPO valuations, maximizing the liquidity arbitrage at the expense of public shareholders.
Why are hedge funds more likely than VCs to push for fuller valuations? They have a short-term focus, they are less likely to care about management’s ability to execute, and most don’t have a sizeable percentage of their portfolio’s value predicated on continued access to the IPO market. However, perhaps the most compelling rationale relates back to prospect theory.
It might be true that VC funds let institutional investors capture easy returns because their returns are so outsized in relation. However, for a hedge fund or mutual fund, their returns will be far less than early-stage VC due to the relatively higher valuations commanded in the later funding rounds. Lower absolute returns and the possibility of even negative returns on their investment should maximize the marginal utility of each dollar, especially when compared to VC investors.
If this psychology holds true, the next round of tech IPOs is likely to look far more like Facebook than LinkedIn, maximizing the value received by the incumbents at the expense of initial IPO shareholders.