Crashing the private party: HF managers rush to set up hybrid funds
Hybrid fund launches are mushrooming as hedge fund managers aim to replicate Tiger Global and D1 Capital’s success
Igor Pakovic 7 JUL 2021
High-profile managers are setting up more and more hybrid public/private funds, as investors are increasingly backing hedge funds which are disrupting the traditional venture capital space.
When the swarm of retail investors attacked hedge funds’ short bets on GameStop in January,
high-profile hybrid fund Dan Sundheim’s D1 Capital ended up losing $4bn in the space of a single month. Meanwhile, in the traditional hedge fund space, half of Gabe Plotkin’s Melvin Capital’s
$13bn fund had been wiped out and White Square Capital, run by former Paulson trader Florian Kronawitter, was hit by double-digit losses.
Months later, Kronawitter shut down his shop as White Square never recovered from the crippling losses it suffered during the meme stock rally, while Melvin was still down about 44.7% this year to the end of May. D1, instead, had already recouped roughly 90% of what it lost by the end of March.
Sundheim was able to recover his Gamestop-related losses mostly through D1’s bets on private companies. When the former Viking Global Investors CIO launched D1 in 2018, he made the choice to invest up to a third of the hedge fund in private firms. Now, as he said at the latest Sohn Conference, the fund’s exposure to privates accounts for half of its assets under management.
Hedge funds investing in private markets don’t represent a new trend in the space, but the amount of hybrid launches – and the number of investments made by hedge fund managers in private markets – is changing the configuration of the launch environment as well as the venture capital/growth industry.
“Hedge funds used to invest in private markets through separate vehicles,” one prime brokerage executive said, with Tiger Global Management, Lone Pine Capital and Coatue being the most
notable examples. “Hybrid funds were less common historically. Now we are seeing more clients raising money for this type of funds, utilising side pockets.”
When Chris Hansen founded Valiant Capital Partners in 2008, he made the uncommon choice to invest up to a quarter of the hedge fund in private companies. Altimeter Capital, Light Street
Capital Management, Alkeon Capital Management and Dragoneer Investment Group have had a similar model for years, just to name a few.
However, in the last 12 months HFM has reported on an ever-increasing number of crossover fund launches: Gaurav Kapadia’s XN; Jay Khan’s Flight Deck Capital; P aul Eisenstein’s Vetamer
Capital Management; Conversant Capital, managed by former Senator Investment Group Michael Simanovsky. And more are coming: Simanovsky’s former boss, Alexander Klabin, is expected to
launch Ancient LP’s first hedge fund, another hybrid fund, with $700m, while Divya Nettimi, who led TMT investments at Viking – where they always had a sleeve of private investments – is gearing up to launch one of the most anticipated debuts in the hedge fund space, another tech- focused hybrid fund.
Most recently, it has been reported that SAB Capital Management’s founder Scott Bommer is set to launch a hybrid fund under Blackstone with close to $2bn in assets. Not only the number of
launches with this set-up has increased, but crossover funds are also attracting more capital than other strategies.
Tiger Global camouflage
Investors deployed $69bn into venture capital-backed companies in the first quarter of 2021, as late-stage investments comprised the highest proportion of deals than at any point since 2010, with 75.2% of all investment dollars allocated to this investment stage, according to the
Pitchbook-NVCA Venture Monitor report.
Though some hedge funds have started to creep into this space earlier, most of them are active from Series B rounds to companies’ pre-IPOs.
“Mostly, they are investing in companies that are going public within 24-30 months, creating a lot of value during their institutionalisation before going public,” says Les Baquiran, founder of Alpine Capital Advisors, the placement agent and advisory firm.
“Our focus is mostly on growth companies. We invest in companies that would otherwise be traded publicly. We don’t invest in Series A or Series B, we are not making bets based on
PowerPoint presentations but on financials of companies that are a lot bigger,” remarks the founder of one West Coast-based hybrid fund.
Traditional VC investors have been getting frustrated with the status of the start-up fundraising environment, as hedge fund’s early movers like Tiger have changed the rules of growth investing by offering cheaper, quicker and less-dilutive capital to private companies.
Recently, Tiger’s Chase Coleman closed one of the biggest venture funds ever with $6.7bn.
According to the Pitchbook-NVCA report, Tiger was also the most active investor in late-stage
rounds in the first quarter of 2021 with 37 deals. Coatue and D1 were respectively 9th and 16th with 15 and 11 deals.
A lot of the success has been due to hedge fund managers deploying a light diligence process, sometimes just 24 hours with a single meeting and a P&L or other available financial data, and they don’t necessarily expect a board seat as is the case at most VC firms.
Cultural and structural differences between the two industries have also played a role in hedge fund managers new role in the growth equity space. “There used to be the perception that private equity managers are better investors, or long-term, strategic investors, but that has changed,” says Stefan Pollmann and Reed Endresen, who lead the private business at Williams Trading.
“There are a lot of issues in traditional private equity funds, the first being that an investor has to commit for 10 to 15 years,” says the manager of a crossover fund, which, instead, can always sell stocks in the public market whenever they want to reinvest capital in a private company.
“We have a significant co-investment capacity for investors. As opposed to traditional private equity players, investors can get access to a complete nimbleness to attack the market,” added the manager of another newly-launched hybrid fund.
In this sense, the crossover funds that have debuted in the last two years hope to replicate Tiger’s success.
New firms Fund manager(s) (former firm)
Avidity Partners Management David Witzke & Michael Gregory (Citadel, Highland Capital) Atreides Management Gavin Baker (Fidelity Investments)
Durable Capital Partners Henry Ellenbogen (T. Rowe Price)
Woodline Partners Karl Kroeker & Michael Rockefeller (Citadel)
Untitled Investments Neeraj Chandra (Tiger Global)
Alua Capital Tom Purcell & Marco Tablada (Viking Global Investors, Lone Pine Capital)
XN Gaurav Kapadia (Soroban Capital)
Vetamer Capital Paul Eisenstein (Lone Pine Capital)
Flight Deck Capital Jay Khan (Light Street Capital)
Conversant Capital Michael Simanovsky (Senator Investment Group)
Hongkou Capital Peter Zhou (Coatue Management)
TBD Robert Bralower (Baupost Group)
Sixth Borough Capital Management Timothy Ramdeen (Altium Capital)
Ancient LP Alexander Klabin (Senator Investment Group)
TBD Divya Nettimi (Viking Global Investors)
Blackstone Horizon (BAAM) Scott Bommer (SAB Capital Management)
TBD Chris Golden (Darsana Capital)
Source: HFM reporting
Tech and healthcare lead the way
Most of these hybrid funds tend to have between 20% and 35% of their capital invested in privates.
“One approach is to have opt-in opt-out structures where the investor elects whether they want to allocate a portion of their capital (e.g., 10%, 20%) to privates. In the opt-in/out model, whether you actually invest in privates becomes a function of how many people opted in or opted out,” says Ben Kozinn, a partner at Lowenstein Sandler.
Although some of the hybrid launches have involved generalist funds, they are predominantly technology and healthcare-focused. Of the latter, ex-Deerfield Management Company partner Alex Karnal has teamed up with Bridgewater Associates COO Brian Kreiter to launch a billion-
dollar healthcare-focused hedge fund, Braidwell Management Company. Great Point Partners co-
founder David Kroin has started Deep Track Capital, while Jason Hong, who was responsible for public and private investments across all healthcare subsectors at Dan Loeb’s Third Point, is
launching Vitalium Capital Partners.
The trend is not surprising, as enthusiasm for the tech and healthcare sectors propelled a huge surge of private deals in 2020. Conversant, which participated in fundraising Lineage Logistics in March with D1, is a rare example of a hybrid fund focused on real estate, investing up to 35% of its capital in privates. As opposed to the technology sector where hedge funds constantly raise capital, Conversant bets on the incubation of new businesses within specific real estate asset categories, buying both majority and minority stakes (most hybrid funds tend to do more of the latter). Others like Manole Capital and newly-launched V etamer target the fintech space.
“LPs are open to hybrid funds, especially when it comes to tech and biotech. Much has been raised particularly from family offices and non-profit LPs like endowments, foundations, and hospitals,” says Baquiran.
In fact, according to a recent report released by Credit Suisse, 53% of allocators invest in private markets equity through hedge funds, with family offices and endowments and foundations being the most active. But investors’ appetite is growing. It is understood, for example, that a number of allocators have asked San Francisco-based Flight Deck – which invests up to 25% in privates with a deep focus on Asian and Latin American markets – to invest up to 60% of the fund in privates.
With private companies staying private longer because they can easily finance themselves, in addition to having less regulatory oversight, there is a record number of unicorns and PIPE transactions. Investors’ interest in these opportunities has grown accordingly, as they can acquire a larger stake and receive increased share allocations during an IPO. Investors like the Los Angeles
County Employees Retirement Association (LACERA) are already making a significant upwards
push in private markets, while analysts at fund of hedge fund (FoHF) managers have indicated to HFM they are keeping an eye on the rise of biotech crossover funds.
In fact, hybrid funds are now competing with traditional hedge funds, as the former are eroding more and more space from the portion of allocators’ portfolios dedicated to hedge fund strategies, rather than private equity.
Deals, deals, deals
Among private equity sub-strategies, venture capital continues to offer the highest performance. The median net IRR for VC and growth equity funds in the 2007–17 decade is 14.1%, compared with 13% for buyouts, according to a recent McKinsey report, as private markets have generally outperformed most public market benchmarks. In a letter to investors in February, Tiger
announced that its private equity business has generated a 33% gross fund internal rate of return and a 26% net IRR. By comparison, the average hedge fund had a median return of 5% during the same period, according to HFM data.
“There is a pocket of opportunities where hedge funds can find great deals that wouldn’t be
otherwise touched by VC funds because of their return threshold,” says a cap intro executive. “VC
funds wouldn’t get involved in later rounds because of the returns they deem too low, while for hedge fund managers these returns are actually very compelling,” as their cost of capital is not as high as that of VC funds.
When it comes to fees, the most common scenario for private investments is to charge a lower management fee and a higher incentive fee compared to the traditional fee structure. “Maybe you don’t have to worry about portfolio risk management every day as you would with public markets, but the costs and the complexity of private investments can be higher than public investments,” says Lowenstein Sandler’s Kozinn.
The high cost of entry is the reason why hybrid debuts are the turf of established managers with an existing VC network, with some of them using rolling lock-up periods to manage investors’
liquidity expectations. Other hybrid fund-specific costs are related to potential compliance headaches as MNPI (Material Nonpublic Information) issues are around the corner.
“If a private company you are invested in is getting bought by a public company, or it is entering into a significant commercial arrangement with a public company, the manager is potentially walking into MNPI problems if you don’t have a physical separation and appropriate information barriers between the private and public investment teams. In most hedge funds, this is often the case,” explains Kozinn.
However, the potential gains seem to be worth the risk. In a recent letter to investors viewed by
HFM, founder and CIO Dan Loeb credited the year’s strong performance to “lifecycle investing”, which includes getting into high-growth investments early at attractive valuations. Third Point’s biggest winners so far this year include tech unicorns Upstart Holdings, SentinelOne and Social
Finance Inc. All three were born out of the firm’s private investment efforts six years ago when the trio were still fledgling companies.
D1 bought into cloud-computing company Snowflake 12 months before it became one of 2020’s biggest IPOs. Altimeter held more than 36 million shares in the cloud data company for a stake worth around $8.3bn at current prices, according to Pitchbook. More recently, Tiger made a $1bn gain Didi, China’s leading ride hailing company, benefitting from the app’s trading debut in the second-largest US IPO by a Chinese company. Coleman’s fund at Tiger also reaped at least $1bn after Peloton’s IPO and scored billions of dollars from an early bet on Indian e-commerce company Flipkart and from backing Chinese retailer JD.com.
Current success has meant these hybrid players have more than enough to recover from any Reddit-fuelled short squeeze on the public side of the portfolio and convince allocators to continue to drive their growth.