Four ways to bypass the venture capital market

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In his 2015 black comedy The big courtAdam McKay brilliantly describes how some astute hedge fund managers have made serious profits betting on a catastrophic implosion of the global banking system.

While few predicted such a precipitous financial collapse, the ability to short sell relatively liquid CDO markets allowed some market participants to bank on when the market inevitably corrected.

A similar trade saw Wall Street hedge fund manager Bill Ackman grab headlines when the stock markets capitulated at the onset of COVID-19.

Today’s global VC markets look like moss. With a lot of money rushed into the asset class, the valuations of many start-ups are rising beyond financial reason.

Additionally, in an environment of post-quantitative easing, with interest rates close to zero, the temptation to switch to closings on a VC bet in the hope of making 10x your investment is significant.

Some signs of euphoria in the market include the record percentages of loss-making companies’ IPOs, the surge in demand for speculative cryptocurrencies, and the huge market value of the venture capital market relative to real capital. deployed.

There is also a circularity about this – above-market returns spur interest and speculation in the industry, in turn driving valuations higher. No one likes to see their neighbor get rich.

In any rational capitalist market, short selling acts as a form of financial gravity. This is good for the market and generally protects the less informed from overpaying.

Yes, occasional jerks lead to the collapse of some hedge funds and the rise of companies like GameStop, but it usually works.

However, since most growth venture capital is privately funded, there is no such counterbalance. Investors cannot short sell a startup’s equity, which means rumors, speculation, FOMO, and bilateral termsheets increasingly introduce valuation risk into the system.

Given where we are in the cycle, it’s worth thinking about what investments one could make to profit from it or at least protect against a revaluation in the venture capital stock market.

What would Michael Burry do? Here are four examples.

1. Owning the debt

Shareholders are more and more inclined to introduce risky debt into their structures. These instruments are nicknamed “vulture financing” for a reason.

Although equity holders protect their dilution, if funding markets dry up, ownership of the company can quickly be transferred to debt holders. In principle, a risky debt holder could acquire a cash-strapped unicorn for $ 1.

Owning the debt of risky insolvent companies could have merit for companies occupying a No.1 or No.2 position in the market.

The prospects for recoverable intellectual property from a major player are likely to be good, especially if it is recovered cheaply through a vulture debt structure.

However, beyond one or two industry leaders, the industry tail is likely to be worthless in the event of a sharp market decline, even for a debt holder.

2. Short listed managers

The very public demise of former listed fund manager Blue Sky Alternative Investments was a textbook case of mark-to-market venture capital valuations not reflecting intrinsic or even market value.

Although the number of purely listed venture capital managers in Australia is limited, a significant global set of opportunities is available.

Although the ownership of the fund manager is totally different from the ownership of the fund or the individual holding company, any structural capitulation would result in a sharp drop in management and performance fees, drastically reducing the value of the equity of the company. management.

3. New selectively short IPOs.

There is no shortage of profitless IPOs valued on hope, and these newly listed companies can be sold short.

A word of warning, these companies often represent the best of VC. Those who survived the “valley of death” may have the best long-term prospects.

So, although this is a potential short film to make widows, they are faced with the same inconvenient truth. Loss-making companies must continue to return to the capital markets for financing. If it dries up, it’s the end of the game.

In addition, price pressure in the IPO market should ebb down the chain and result in more digestible valuations in the first rounds.

4. Be under-indebted in your investments

A major trap for venture capitalists is going too fast, too early, and not having enough dry powder to participate in follow-up rounds, or even down rounds where the price is less than the increase. former.

In the adventure, the first check is rarely the last given the capital-hungry nature of start-ups. Therefore, it is essential to size the total investment during the trip.

Those with undeployed cash are likely to be serious winners from any market correction, especially good deals emerging from bearish turns.

The strategy here would be to have modest but not complete investment exposures to access shareholder rights in the event of a recapitalization.

Over the decade, being long in venture capital has almost certainly been a lucrative business – even taking into account today’s valuations. However, selectively holding capital in bull markets, owning different parts of the capital stack, including debt, or running out of a few IPOs, are a few ways to add portfolio protection while staying long.

With opportunities to invest in energy transition, personalized genomics and quantum computing, the best is yet to come.

Neil Vinson is a portfolio manager at Tanarra Capital.


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