We all know there’s a huge gulf between the way Wall Street looks at technology and the way Silicon Valley looks at technology. The question is whether anyone can breach it.
Well one of the top-ten hedge funds on the planet is trying. Coatue Management is launching a $300 million fund to invest in high-growth, pre-IPO startups. Its No. 2 executive, Thomas Laffont, has moved to Menlo Park to manage the fund out of an office nestled next to Andreessen Horowitz Partners in the Rosewood complex on Sand Hill Road.
Coatue will also have the ability to invest up to 10 percent of existing capital into private companies. That means Coatue actually has up to $1 billion to invest in private tech companies– a significant infusion of capital in what some people already feel is an already crowded part of the market.
The firm has quietly already done one deal: Coatue was an undisclosed investor in the most recent Box.com round last year.
But Coatue’s money comes with a catch of sorts. Laffont doesn’t represent dumb money looking for billboard companies to establish himself on the West Coast. If he is going to invest in your company, he is going to use his huge research staff to dig deep into your company the way a portfolio manager digs into a Wall Street stock.
He’s going to come up with a valuation that makes sense based on the business fundamentals and what Wall Street is likely to value that company at, should it go public in the next two to five years. ”The Valley does a lot of things well but there is no better instrument for setting price than the public markets,” Laffont said in an exclusive sit down with PandoDaily about the new fund.
Laffont, and his brother Philippe who launched Coatue back in 1999, certainly know public market tech investing. Bloomberg ranks Coatue as one of the top ten hedge funds on the planet. It bet heavily on Apple back in 2003. But it’s also known for placing big bets on smaller tech companies that aren’t necessarily the flavor of the moment, like the long-troubled Equinix or Virgin Media. (All of this is according to existing press reports and a rare interview with Philippe Laffont on Bloomberg just before Facebook’s IPO. Laffont declined to discuss anything about the hedge fund side of the business as a condition of our interview.)
The hole the Laffont brothers see in the Valley is a voice that represents Wall Street, but it’s an open question whether Silicon Valley actually wants a Wall Street-minded voice in these deals.
Part of the contentious gulf between Wall Street and Silicon Valley is around valuations. Starting at the earliest days of a company, a venture capital valuation has little to do with any business fundamentals or even what a company could be purchased for at the time the price is set. No company that’s little more than a fledgling product is actually worth $5 million to $10 million –standard prices for a series A deal. And that’s to say nothing of insane runaway series A prices like Viddy’s $300 million series A.
The price has to do with potential, and it has to do with power– namely what someone has to pay to get in and to beat out competitors.
The implications of high bets are limited at the early stages of a company. The only money that’s at risk as early stage valuations get frothy is the VCs’ and they’re the one setting the prices. They only have themselves to blame if it goes south. And terms like liquidation preferences — which mean that VCs get repaid first in the event of an exit — mean they’re protected on the downside.
But as companies get closer to an IPO, that methodology of price setting can get investors, entrepreneurs, and employees who own stock into trouble. That’s what we saw play out with the mega-IPOs of the last few years, and that’s exactly why limited partners hate it when VCs try to invest in growth stage companies. They verge on acting like hedge funds, and they aren’t hedge funds.
The market for pre-IPO growth investing was cracked open by Yuri Milner back in 2009. Milner saw quicker than almost anyone that the hottest companies were waiting longer to go public. He stepped in to give them seemingly price-insensitive funds at favorable terms. And because there was so little competition in this space, he cleaned up doing it.
As venture capitalists sought to compete with Milner, they too paid up. The peak being the January 2011 Groupon deal for nearly $1 billion — most of which went into the early investors and employees pockets. Many VCs applied mostly the same logic to a deal like Groupon that they had in the venture world: Could we at least get our money back in a worst case scenario? Others were just buying big names to put on their websites to help regain their mojo with early stage companies.
But none of these firms were approaching these deals the way a hedge fund would. None had armies of researchers calling hundreds of Groupon merchants and asking whether the deals were good for them. None had armies of researchers calling CIOs to ask if they were actually embracing a certain cloud vendor.
And guess what? Amid this pre-IPO mania, the Valley generally did a terrible job at valuing these shares. More surprising: Despite the lousy aftermarket performance of nearly everyone but LinkedIn, there are no signs of that abating anytime soon.
Spotify closed a fifth round of funding at a whopping $3 billion valuation last November. Sure, that was down from the rumored about $4 billion valuation earlier in the year. But let’s not pretend for a second that $3 billion is a rational price Spotify would be able to get in any near term exit. It’s a venture-style valuation, as applied to a late stage deal.
More recently, Twitter sold shares on the secondary market at a $10 billion valuation. Twitter is a phenomenon no doubt, but its business is admittedly nascent. As August Capital’s David Hornik wrote on his blog, “I have heard of short term memory, but this borders on amnesia. Were the buyers in this latest secondary transaction asleep during the Facebook IPO?”
What Coatue is offering pre-IPO companies is markedly different: The perspective of the necessary evil of the startup game that all entrepreneurs love to hate, Wall Street. It doesn’t seek to dislodge VCs or join boards, and Laffont says his term sheets will be as simple as one sheet of paper saying what number of shares they are buying at what price. But it will not overpay for shares based on momentum, buzz, froth, or the desire to put a logo on a website.
Coatue isn’t the only growth stage investor with a Wall Street mentality. Tiger Global, T Rowe Price, and Fidelity have all been active in the market, in addition to other mutual funds that have come and gone. But Laffont argues that Coatue can move much more quickly than these mega firms and has the advantage of being a fund completely focused on technology. “I’m the second most senior person in the firm, and I’ve moved my family here,” he says.
The fund’s structure is set up dramatically differently to make sure its only incentive is buying a stock for a good price. A venture fund gets commitments and then draws down that capital when it’s time to make investments. Coatue, by contrast, drew down its $300 million fund on day one, and that money is already in the public markets earning a return. For them to invest in a private company, they pull money out of the public markets. Right now, tech stocks are priced pretty low. Box could conceivably be the only deal Coatue does this year, or it could do twenty. They earn the same fees either way. There’s no artificial pressure to “put money to work.”
Coatue may be wrong, of course. But with each deal, it has to believe it can make a better return on that company than it could in the public markets. “The check on pricing in the public markets is that people can sell,” Laffont says. “There is no check in the private markets. Indeed most investors can only buy. That causes a rising soufflé and then people throw it into the public markets to see what happens.”
That novel structure means it’s hard to tell how much of a force Coatue may become in the venture market. It could invest up to $1 billion over the next three years, but it may invest next to nothing if the deals aren’t there at the right price.
Entrepreneurs whose egos are tied to ever-escalating valuations likely won’t do deals with Coatue. But those who look at what Facebook just went through and genuinely worry about this disconnect between the Valley and Wall Street might. And once Coatue is invested, it can leverage this research to help answer other questions about their business, such as, “Cisco wants to buy me for $3 billion… should I take it? Or could I be bigger than that in a few years as a publicly traded company?”
A lot of Laffont’s views are contrary to typical Valley thinking. For instance, many companies have credited small initial floats of stock to strong aftermarket performance, because supply is limited. Laffont argues that constraining the stock only makes it more volatile and puts too much pressure on lock ups expiring. If a fund manager can’t get his hands on much of a stock, he’s also more likely to dump it if the company hits a road block. He doesn’t have much skin in the game, nor does he have much upside for sticking with it. “That’s just the portfolio manager’s mindset,” Laffont says.
Of course, there are those in the Valley who think Wall Street is its own emotional momentum crapshoot that focuses way too much on rumor, macro-trends, and short-term fluctuations in a company’s performance. Unlike VCs, this logic goes, Wall Street doesn’t get the long game, and hence it doesn’t really get technology. Can anyone predict how Wall Street will price something?
Laffont pauses when I ask this question, as if it’s the first time anyone ever has. “If that weren’t true, I wouldn’t have a business,” he says.
[Image courtesy Steve Wampler Photography]