Hilliard Equities

        
         Private Equity Investment Management   
   

Home
Experience
Assignments
Publications
Contact Info

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


Working Paper, May 2004

SHOULD A VENTURE CAPITAL FUND ACT MORE LIKE A “VENTURE HEDGE FUND™”?

Maximizing Private Equity Returns through Public Market Hedging

Charles Baden-Fuller
Cass Business School, City University
London EC2Y 8HB, England
c.baden-fuller@city.ac.uk
&
Bill Hilliard
Sol C. Snider Entrepreneurial Research Center
Wharton School, University of Pennsylvania
bill@alum.mit.edu 


ABSTRACT

This paper suggests modifying the venture capital investment paradigm to optimize and amplify venture capital partnership returns. IRR’s and cash-on-cash returns can be increased by abandoning the “mutual fund” approach to venture investing, and adopting that of the “hedge fund”. The strategies proposed enable venture investors to efficiently increase investment leverage in portfolio companies after they have proven themselves winners. Venture capitalists can use the financial markets to increase partnership value by trading in the stock of “winning” portfolio companies’ rivals on the basis of the venture capitalist’s asymmetric knowledge. By making a profit on the “short” trade, the venture capitalist is able to recapture from the public market profits that would otherwise be foregone by their investment. This paper provides guidance on how these effects arise, how valuable they are, and what are some of the pertinent regulatory and ethical questions involved. Specific term sheet issues are addressed which enable a venture partnership to adopt this investing style within the guidelines set by current US statutes and case law.

© Charles Baden-Fuller and Bill Hilliard, 2004


SHOULD A VENTURE CAPITAL FUND ACT MORE LIKE A “VENTURE HEDGE FUND™”?

Maximizing Private Equity Returns through Public Market Hedging

INTRODUCTION

The Venture Capital (VC) industry has remained largely unchanged in its investing style since the industry’s birth. Venture partnerships raise risk capital from their limited partners, take positions in pre-public firms, and ride those positions until an eventual exit. Essentially they 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 venture capital partnerships can increase internal rates of return (IRR's) and cash-on-cash returns by acting more like “Venture Hedge Funds. ” Just like hedge funds, venture capital partnerships should identify opportunities to invest in short positions that relate to their long positions so as to increase returns from profitable investments. Additional hedging strategies may also prove profitable.

Most new ventures fail. Fewer than one in ten new ventures earn a positive return for their investors [Mason and Harrison, 2002, Manigart et al., 2002, Kleiman and Shulman, 1992, Bygrave 1989]. 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, subsequent financings may never occur. The companies may require no additional financing. Even if the companies do raise additional funds, investors from previous rounds are typically limited in their subsequent investment amounts based on the amount of capital already invested in previous rounds. 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.


“DISRUPTIVE INNOVATIONS” CAN BE PROBLEMATIC

“Disruptive innovations” are defined as those where the innovation alters the dynamics of competition [See for instance Christensen, 1997]. To varying degrees, all successful venture backed firms are disruptive of their current market environments—they disrupt the flow of customer spending away from other companies. This disruption might be direct, as in the case of Southwest Airlines or Jet Blue versus other US air carriers flying similar routes, or it might be less direct. One thing is certain, if a firm attracts cash payments from its customers, then other companies who lost out on those same cash payments will be adversely affected.

The problem with investing in disruptive firms is that the investment gains resulting from disruptions are often elusive and delayed; whilst the losses in market capitalization suffered by the disrupted companies are often more immediate. Ventures that disrupt markets find that it takes time and effort to translate market penetration, favorable partnering deals, design wins or other impactful company progress into profits. However, the companies threatened by the disruption find themselves facing a very clear and immediate threat. Financial markets react quickly to threats by adjusting their expectations about the future profits of the disrupted corporations, even when the actual disruptions only affect their markets in the distant future.

INCREASING PORTFOLIO LEVERAGE IN PROVEN WINNERS

Venture capital partnerships adopting our proposed paradigm can use the above thought process to their advantage by securing permission from their limited partners to take both long and short positions in their portfolio investments and related companies.

Venture capital investors in pre-public firms are often in possession of potentially valuable asymmetric information about the actions of the firms in which they have invested [Aboody and Lev, 2000]. This information relates to the timing and potential efficacy of the effect of the invested firm’s actions on its rivals. For example, the firm may be a new entrant that is about to launch a very competitive product that better satisfies market requirements at a considerable discount to current market pricing. Such actions have the potential to change the competitive landscape and so reduce the value of the established rival companies. When those rival companies are quoted and traded, the VC partnership can capture additional value out of their “winning” investment by trading in financial options in the rivals’ stock.

The sequence of events is broadly as follows:

1. Armed with the understanding that a disrupting firm might someday have a financial impact on the market capitalization of its rivals, investors add to their investment “term sheets” explicit information rights permitting them to utilize any information learned about unrelated third parties derived from their investment in the portfolio firm.

2. After the portfolio firm matures and 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 partnership purchases put options (or similar derivative instruments with equivalent effects) on these rival companies before the knowledge of the disrupting firm is widely known or widely appreciated.

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 VC partnership is then able to exercise the options (cash-in the derivatives) at a profit.

 

Proposition 1: Investors in firms creating disruptive innovations can improve the returns to their investment by utilizing asymmetric information and purchasing put options or similar contracts on the stock of rival companies before knowledge about the success of the disruptive innovation is widely known.

The profit from this proposed strategy can be very attractive. This profit is both immediate and additional to the profits expected from the investment in the firm that is launching the disruptive innovation — increasing fund IRR's and cash-on-cash returns. Moreover, this profit could even be larger than that from the investment in the disrupting firm itself.

IS THIS STRATEGY PROFITABLE?

Assume two firms, disruptive innovator A, and disrupted public company B. A is the innovating firm that plans to introduce a new cost-reducing disruptive process to the market. B is the incumbent company (or group of companies). How important is the value of the “option” in firm A (i.e., the real option embedded in the original investment in firm A that serves as the ante to permit the investor to potentially later purchase a put option on A’s rivals) relative to the profits from the investment value itself? The answer is that the value could be very large; many times the total future profits from the original investments in the firm creating the disruption. We begin by looking at three case examples: airlines, computer peripherals and medical devices and then we look at statistical work on 384 new product launches across 101 companies in 39 industries.

Whinston and Collins [1992] monitored the effect of 24 announcements by the airline People Express. Each announcement was a stated intention to enter new US domestic routes between two cities during 1984-85. They found that each announcement had a significant negative effect on the market capitalization of incumbents and a significant positive effect of the price of People Express’s stock. The fall in any given incumbent’s stock price was about four times larger than the gain in stock price experienced by People Express at the time of the launch. This suggests that the potential gain from trading put options (or some equivalent derivative) may be larger than the potential gains from the long investment itself. Even more critically, the gains from the put arise immediately, whereas the stock appreciation gains from the underlying investment are delayed until the VC is able to exit to their venture investment.

To reinforce the point; investors in People’s Express ultimately lost their money in their investment. Nevertheless, the investors could still have made a profit if they had been able to undertake the hedging financial play.

In the computer industry: in 1987, a VC-backed company named Phoenix Technologies, then private, announced that it was planning to launch a product that would disrupt Adobe’s postscript printer technology. On the announcement, Adobe’s stock dropped over 36% over a two-month period. Investors in Phoenix Technologies could have increased their return immediately and dramatically by purchasing, at a suitable time, a put on Adobe’s stock (provided they did not have any other relationship with Adobe—see the “Is it Legal?” section below).

In the medical device industry, on September 17, 2003 it became clear that a device called a “drug-eluting stent” from Boston Scientific would be a disruptive technology to a division within the diversified pharmaceutical company Johnson and Johnson. The stock of J&J fell 1.4% in 15 minutes and 2.5% on that day. Moreover, the stock price of the S&P 600 smaller cap SurModics (NASDAQ: SRDX) dropped 13.7% that day because, at the time, SurModics supplied the technology to J&J that was used in its “drug-eluting” stent. Investors in Boston Scientific, after taking appropriate precautions, could have increased their wealth by purchasing put options on either SurModics or on J&J at the appropriate time.

In each of the above cases, the investors in the firms creating the innovations 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.

In practice, knowledge of potentially disruptive innovations is often well known by venture investors in a firm before the broader markets take notice. Venture investors learn about many small firms experimenting with innovations at any one time. As investors, they attend regular board meetings and conduct frequent discussions with management.

The moment when the knowledge becomes effective and is noticed by the market is when industry conferences give visibility to the activities of these firms. Another way of gaining attention is to form an alliance with credible partners [Chan, Kensinger, Keown and Martin, 1997; Das, Sen and Sengupta 1998; Koh and Venkatraman 1991; McConnell and Nantell 1985.] In these instances there is a long time delay during which the investors in the disruptive technology have an “early warning” opportunity to place their bet.

Chen et al. [2002] provide further support for the effect of announcements on the stock price of disrupted companies. They examined the competitive interaction of new product announcements using event study methodology and found that announcements had a negative and statistically significant effect on competitors within a narrow two-day window. The announcements studied by Chen et al. were not just disruptive technologies but also non-disruptive ones as well. Moreover, the competitors studied were defined by a wide industry definition rather than a narrow product-based criterion. In addition, Chen et. al.’s test of the price drop was restricted to a narrow two-day window in comparison to a 260-day benchmark, which might be more typical of an options contract. This study, supporting our hypothesis, is therefore much more demanding than would be the case with the Venture Hedge Fund strategy we propose.


Proposition 2: Judging a venture investment solely based on its expected cash flows would be misleading if the gains made from the exploitation of rivals’ losses were ignored. Further, disregarding these gains can lead to sub-optimal returns to the investor. In the final analysis, it is the combination of the discounted cash flow (DCF) of the investment and the gains from the paired action in the financial markets that determines the true value of a potential investment in the disruptive innovator.


This brings us to another point: investors in portfolio firm A may not be confident that A will succeed in disrupting B, but they might still possess, and benefit from, asymmetric information. Disruptive innovators come in packs. Typically, there are many companies working on parallel tracks. Realization that a break-through is about to occur may persuade the market that B’s value is under-threat even if the market may not know which of the many companies in the pack will win. Studies of disruptive innovations [such as Christensen 1997] give examples of these phenomena. Thus, an investor in one of the disruptive firms in the pack may very well attain and benefit from asymmetric information about how well the “pack” is progressing, even if the investor’s own firm is not the one that will make the breakthrough and create the market disruption.


Proposition 3: Trading in stock substitutes gives investors the chance to earn a return that would otherwise have been missed due to execution problems within the actual firm in which the investor invested.


The returns are greatest when the rival incumbent has monopoly power

The above examples have several features making the potential gains large. The stock market clearly believed that the incumbents had some monopoly power. In addition, the incumbents had high costs associated with exit in the sense that the assets they possessed were inflexible and represented large sunk costs. For these reasons, entry obviously threatens the incumbents’ stock prices. From a theory perspective, the greatest gains to investors in A will come when B has a large margin between price and marginal costs.


Proposition 4: The value of using the options contracts are likely to be greatest where the rival incumbent company is a monopolist, and least where the rival is one of many companies splitting a market.

Timing, transactions costs, risk and uncertainty

Until now, we have ignored several important factors such as the carrying costs of purchasing options and uncertainty over the effects of the disclosure. 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 information possessed by the VC investors in their competitors—thereby reducing, or eliminating, the value of the put.

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 any underlying venture investment in the disruptive firm itself. Thus the venture fund may find that leveraging its investment in firm A with derivatives is a very attractive strategy; particularly since those derivatives provide an opportunity to multiply returns with arguably the same or lesser risk than the original investment itself.

What are the approximate transactions costs one might expect? To provide a tangible example of a real venture situation, we give some data for investors in a young book-selling business trading put options on a well-traded stock substitute that has a narrow portfolio – Barnes and Noble. We looked at Barnes and Nobel (symbol: BKS) put options with various expiration dates on August 23rd, 1999, when BKS’s $25 stock price was equivalent to the strike price of the options. BKS options with two-month, five-month and eight-month expirations became profitable with only 2% stock-price drops. Indeed, suppose one was to believe that the announcement could move the stock price of BKS by say 6% in 1-2 months, or 13% in 5-8 months, then this example indicates a potential to earn greater than 30% cash-on-cash returns; and internal rates of return that are very high (480% and 150% respectively). It is easy to see that a modest outlay in this arena would greatly improve the return on the venture investment as a whole.

Our current research cannot yet recommend a specific percentage of a VC portfolio that one should allocate toward purchasing puts. However, a VC would likely approach this issue by calculating the amount of capital allocated toward, but uninvested in the specific disruptive portfolio firm (often called the “dry powder” still allocated to the investment). The combined short and long positions related to a single portfolio investment would never exceed the maximum dollar amounts or percentages that the VC would otherwise invest in a long position in that disruptive firm alone, and would likely be less.


IS THIS NEW VC INVESTMENT PARADIGM ETHICAL, AND IS IT LEGAL?

There is a substantial literature on the use of asymmetric information posed by managers when they trade in the stock of their own companies for their own personal gain. Such activities are typically labeled insider trading and are outlawed in most countries.

Our proposed case is quite different. We are considering the use of what is technically known as trading in stock substitutes, that is the use of information that one investor possesses from his relationship with a firm in which he/she has invested that affects the stock price of another legally and institutionally unrelated company.

Is it ethical?

Economists have argued that investors in innovations need some protection. The argument is usually portrayed in the context of defending patent laws. The same argument, however, applies to our trading strategy.

There is a famous discussion of the causes of the poor returns to innovation set out by the Nobel Laureate Arrow [1962]. As Arrow points out, when a firm introduces as disruptive innovation threatening the survival of competitors, subsequent competition forces down prices. This reduces the profits available to the innovator. Competition, normally considered a blessing for consumers can be adverse because the returns to the investors in the innovative process may lose out even when the innovation is “socially desirable”. Arrow showed that this danger would discourage investment in many radical innovations.

The problem identified can be overcome, in part or in full, if inventors can make direct contracts with customers in advance. Customers can promise to the inventor that s/he will receive his/her rewards directly through purchase contracts either at a pre-determined price, or by side payments. Alternatively, the innovator can make contracts with the suppliers of complementary goods to make the gains. For instance, Eli Whitney, the inventor of the cotton gin, would have made exceptional profits if he had abandoned his attempts to patent the machine and instead focused attention on investment substitutes by buying up land suitable for raising cotton; which, at the time, was trading at very low prices [Hirshleifer 1961].

Our proposed strategy for investors is an application of a similar investment substitute strategy. The investors who hold stock in the disrupting firm trade on the stock of the unrelated disrupted companies. Our strategy therefore builds on a long line of discussion about how investors in innovations can improve their returns with ingenious strategies. In extreme cases, it could be the possibility of the options trade that makes an unprofitable, but socially-worthwhile, investment realisable; specifically because the options trade yields a more immediate cash benefit that is additional to the rather uncertain and distant pro forma returns otherwise inherent in such an investment. Thus there will be cases where the options trade will allow projects to be financed that could not be financed otherwise (except perhaps by government subsidy). As noted above, such cases will improve society’s welfare.

Who pays for the trades? The consumer does not pay directly. Instead, it is the issuers of the instruments. In most markets, the sellers of put options and derivative instruments are pension funds, who undertake the positions in the hope of increasing their returns. Where the sellers of the options are pension funds representing the same class of consumers as the future users of B’s current products, the put option is a surrogate contract with B’s customers, overcoming the incomplete contract problem and enabling A to extract the surplus. In other cases, speculators are merely standing in for the consumers. In either case, we are bridging the financial markets for B with the assets markets of A’s invention.

It must be stressed at this point that there is a big difference between trading in derivatives on rival companies (stock substitutes) to help finance innovations versus the use of insider knowledge to reap personal gain. The societal gains from insider trading are usually measured in terms of more efficient trading on financial markets and more efficient signals—gains that are widely disputed, and in which there are significant agency problems creating ethical concerns. In contrast, trading by investors in stock substitutes helps finance disruptive innovations. This trading is much more clearly socially beneficial in the sense that there are no agency problems at all. The profits earned from these trades directly and unambiguously benefit the VC investors funding the innovation process.


Is it legal?

Some have expressed concern that our proposed strategies for the investors are not legal. The concerns centre on the fact that investors in A are using non-public information to make a gain on the change in the stock price of the threatened company B. In other words, the use of “material, non-public information” gained through an investment in a “Disruptive private company A” would violate insider-trading laws related to trading publicly traded stock in “Disrupted public company B.” We have carefully trawled the insider-trading statutes in the US, and have discussed our example with lawyers and experts. Although the authors 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 Ayres and Bankman [2002], who explicitly discuss the legality of trading in stock substitutes. Neither the Supreme Court case nor Ayres and Bankman discuss our example of venture investors increasing their returns to help finance disruptive innovations, but they both discuss the more general case of holders of material, non-public information on a company with which they have no legal connection who choose to trade on that information for personal benefit.

SEC Statutes:

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…” 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.

Now our 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 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 or 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 (i.e., company B is an unrelated player in the market competing directly or indirectly with company A). In other words, the investor must not have any direct or indirect relationship with company B that would subject the investor to insider trading restrictions when trading on public company B’s stock.

The only other issue of concern is that investors in A have a duty to firm 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 assure 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 a document called a “term sheet” for the investment offer. The term sheet becomes the basis for all final investment documents. To assure 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 investment term sheets. Sample terms sheet wording used by one of the authors is as follows:

“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.”


US Supreme Court case law:

It is not enough for the layperson to read the SEC statutes. One must also study how the courts interpret the law. There is a series of U.S. Supreme Court judgments reinforcing our viewpoint.

Cady, Roberts (1961) established the duty of an outsider, such as a brokerage company employee, to either disclose material, non-public information or abstain to trade. It stated that outsiders “do not automatically have the special obligation of corporate insiders, unless:…[F]irst, the existence of a relationship giving access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone, and second, the inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing.” In the Cady, Roberts case, it was determined that there was a special relationship between the trader and the corporation’s shareholders in which the trade occurred, and that this special relationship applied to the tipee as well. In Cady, Roberts, the defendants violated section 10(b) and Rule 10(b)-5 because they were under a fiduciary duty to the listed company’s shareholders.”

Chiarella, and Dirks (1980 and 1983) reinforced this line of reasoning as well. In addition, Chiarella defined “front-running” by indicating that certain individuals such as lawyers, accountants and others may have limited but special, confidential relationships with a corporation that gives them access to information intended only for corporate purposes. As such, these people must abstain from trading because they are deemed to be “temporary insiders” until the confidential information has been disclosed and absorbed by the market.

SEC v. Newman and SEC v. Materia (1981 and 1985) were among the prominent cases that established what is referred to as the “misappropriation theory” of insider trading. These two cases changed the focus of Section 10(b) away from the defrauded purchaser or seller of securities; and instead, focused on the trader’s relationship to the entity from which the information was obtained. These cases determined that any breach in duty to any person in obtaining the information—even if there is no breach of duty to the purchasers or sellers of securities in the target companies—triggers the “in connection with” requirement of Section 10(b). As such, if there is any breach of duty to any party, then the breaching party is deemed to have misappropriated information. It should be noted that in our proposed transaction, we stress that the investors in A must take care (inter alia) to have cleared their relationship with A and by implication with the other investors in A about the use of the information.

In Carpenter (1986) there was a breach involving Mr. Winans, a writer for the Wall Street Journal (and his tipee Carpenter), who misappropriated for personal profit the Wall Street Journal’s publishing schedule. This gave them market information about the stocks that were to be covered in the Wall Street Journal’s “Heard on the Street” column. The Second Circuit Court used Carpenter to increase the scope of misappropriation theory related to securities fraud, but the US Superior Court was split four to four and issued no opinion on the securities fraud aspects of the case. Instead, Carpenter was convicted of mail fraud.

United States v. O’Hagan (1997) is the latest Supreme Court ruling and defines current US law. It “outlaws trading on the basis of nonpublic information by a corporate ‘outsider’ in breach of a duty owed not to a trading party, but to the source of the information.” The majority of the Supreme Court justices conceded, “if Mr. O’Hagan had informed his law firm of his intention to use the misappropriated information to trade on the target stock, there would have been no section 10(b) violation”.

In summary, the authors can point to a long line of Supreme Court judgments clarifying that investors may utilize “material, nonpublic information” to trade in stock substitutes under section 10(b) of the Securities Exchange Act of 1934, provided that the investor has no conflicting fiduciary duty to the disrupted company B; and that s/he has been granted permission from disrupting firm A to do so.


CONCLUSIONS

This paper questions whether the current investment paradigm used by venture capital partnerships optimizes portfolio returns for their asset class. Venture capital partnerships can increase IRR’s and cash-on-cash returns by adopting a “hedge fund” approach to replace their current “mutual fund” approach to venture investing. The strategies proposed VCs to increase investment leverage in portfolio firms after these firms have proven themselves winners.

We argue that VCs can use the financial markets to add value to investments that threaten incumbent companies by short trading stock substitutes based on the venture capitalist’s asymmetric knowledge. By making a profit on these “short” trades, the VC partnership captures extra profits that would otherwise be foregone by their investment.

Our paper provides guidance as to how these effects arise, how valuable they are, and discusses some of the ethical, practical and regulatory issues involved. Further research can help identify optimal guidelines on proportions of venture portfolios that might optimally be allocated to short (derivative) versus long investments, optimal instruments in which to invest, relevant market characteristics affecting returns, and additional guidance on timing.

Once one is open to a new and better paradigm for venture investment, further research might investigate other hedge fund strategies that could apply to venture capital. One such idea proposed to the authors by a reviewer would be to buy derivatives that essentially short the future NASDAQ as a way of hedging market risk. Because portfolio valuations are almost directly correlated with stock market returns, with minimal lag, a logical extension of the “venture hedge fund” paradigm would be to purchase derivatives with lags equal to expected life of each venture investment. This might enable a Venture Hedge Fund partnership to mitigate some of the systemic risk endemic to venture investing. Other hedge fund techniques might also be studied as ways to further capture exogenous gains from adapting a Venture Hedge Fund investing approach.

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] A term trademarked by, William Hilliard, one of the authors

[2] The proposed strategy has some obvious limitations.  We are only dealing with innovations that are disruptive; that is, they are capable of influencing market structures and stock prices of rivals.  Although there is no requirement that the firm doing the disruption be listed for the strategy to work; the stock of the threatened firm (the “disrupted firm”) must be traded in well-developed financial markets. Since, a large amount of the US and European economies are populated by quoted firms, and a significant goal of venture financiers is to capture the maximum profit from the rights and preferences negotiated into their investments, our paper has potentially a wide applicability.

[3] The authors wish to thank Art Reidel of LightSpeed Ventures in Menlo Park who suggested this strategy as just one additional refinement to our Venture Hedge Fund investment approach.

 

REFERENCES

Abody, D. and B. Lev (2000) “Information Asymmetry, R&D, and Insider Gains” Journal of Finance 55(6) 2747-2766

Amram, M. & Kulatilaka, N. 1999. Disciplined Decisions: Aligning Strategy with the Financial Markets. Harvard Business Review, 77 (1), pp. 95 - 104.

Arrow, K. 1962. Economic welfare and the allocation of resources for inventions. In R. Nelson (ed.) The Rate and Direction of Inventive Activity, Princeton, NJ: Princeton University Press.

Arshadi, N. and Eyssell, T. (1993). The Law and Finance of Corporate Insider Trading: Theory and Evidence. Boston: Kluwer Academic Publishers.

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

Baden-Fuller, C., Dean, A, McNamera, P., & Hilliard, B. Raising the Returns to Venture Finance, working paper in press.

Barnett, W. P., Greve, H. R. & Park, D. Y. 1994. An evolutionary model of organizational performance. Strategic Management Journal, 15 (Winter), pp. 11 - 28.

Bartlett, C. A. & Ghoshal, S. 1993. Beyond the m-form: Towards a managerial theory of the firm. Strategic Management Journal, Vol. 14 (Winter), pp. 23 - 46.

Bebchukck, L.A. and C. Fershtman (1994) “Insider trading and the Managerial Choice among Risky Projects” Journal of Financial and Quantitative Analysis 29(1) March, 1-14

Black, F. & Scholes, M. 1973. The pricing of options and corporate liabilities. Journal of Political Economy, 81 (3), pp. 637 - 654.

Bowman, E. H. & Hurry, D. 1993. Strategy through the options lens: An integrated view of resource investments and the incremental-choice process. Academy of Management Review, 18(4), pp. 760 - 782.

Brealey, R. A. & Myers, S. C. 1996. Principles of Corporate Finance. New York, NY: McGraw Hill.

Burgelman, R. A. 1994. Fading memories: A process theory of strategic business exit in dynamic environments. Administrative Science Quarterly, Vol. 39 (1), pp. 24 - 56.

Bygrave, W. 1989, “Early rates of return of 131 venture capital funds started 1978-1984” Journal of Business Venturing 4: 93-105

Chan, S., Kensinger, J., Keown, A. and Martin, J. (1997). Do strategic alliances create value. Journal of Financial Economics, Vol. 46 (2), pp 199-221.

Chen S-S, K. W. Ho, K. H. Ik, C. Lee (2002) How does strategic competition affect firm values? A study of new product announcements. Financial Management 3:67-84

Christensen, C. M. (1997) The Innovators Dilemma: When new technologies cause great firms to fail Boston: Harvard Business School Press

Coase, R. 1960. The problem of social cost. Journal of Law and Economics, Vol. 3: 1 - 44.

Das, S. Sen, P. and Sengupta, S. (1998). Impact of Strategic Alliances on Firm Valuation. Academy of Management Journal, Vol. 41 (1), pp 27-41.

Dixit, A. K. & Pindyck, R. S. 1994. Investment under Uncertainty, Princeton, NJ: Princeton University Press.

Dixit, A. K. & Pindyck, R. S. 1997. The options approach to capital investment. In John Seeley Brown (ed.), Seeing Things Differently: Insights on Innovation, Boston, MA: Harvard Business Press.

http://www.e*trade.com, 29th January 2001

http://www.ee-online.com, 29tyh January 2001

hhtp://finance.yahoo.com/q?s=EBAY, April 2003

Hu, J. and T. Noe (2001) “Insider Trading and Managerial Incentives” Journal of Banking and Finance 25: 681-716

Jeng, L.A., A. Metrick and R. Zeckhauser (1999) “The Profits to Insider Trading” National Bureau of Economic Research working paper number 6913.

Kleiman, R.T. and J.M. Shulman, 1992, “The risk-return attributes of publicly traded venture capital” Journal of Business Venturing 7: 195-208

Kogut, B. 1991. Joint ventures and the option to expand and acquire. Management Science, Vol. 37 (1), pp. 19 - 33.

Koh, J. and Venkatraman, N. (1991). Joint Venture Formations and Stock Market Reactions: An Assessment in the Information Technology Sector. Academy of Management Journal, Vol. 34 (4), pp 869-892.

Kyle, A.”Informed Speculation with Imperfect Competition” Review of Economic Studies vol 56: 371-356

Leonard-Barton, D. 1992. Core capabilities and core rigidities: A paradox in managing new product development. Strategic Management Journal, Vol. 13 (Summer), pp. 111 - 125.

Leslie, K. J. & Michaels, M. P. 1997. The real power of real options. McKinsey Quarterly, No. 3, pp. 4 - 22.

Levinthal, D. A. & March, J. G. 1993. The myopia of learning. Strategic Management Journal, Vol. 14 (Winter), pp. 95 -112.

Limmack, R. (1991). Corporate Mergers and Shareholders Wealth Effects 1977-1986. Accounting and Business Research, Vol. 21(83), pp 239-251.

Luerhman, T. 1997. What’s it worth? A general manager’s guide to valuation. Harvard Business Review, Vol. 75 (3), pp. 132 - 142.

Luerhman, T. 1998. Strategy as a portfolio of real options. Harvard Business Review, vol. 76 (5), pp. 89 - 99.

MacMillan, I. C. & McGrath, R. G. 2000. Assessing technology projects using real options reasoning. Research-Technology Management, Vol. 43 (4), pp. 35 - 49.

March, J. G. 1991. Exploration and exploitation in organisational learning. Organization Science, Vol 2 (1), pp. 71-87.

Mc Connell, J. and Nantell, T. (1985). Corporate Combinations and Common Stock Returns: The Case of Joint Ventures. The Journal of Finance, Vol. 40 (2), pp 519-536.

McGrath, R. G. 1997. A real options logic for initiating technology positioning investments. Academy of Management Review, Vol. 22 (4), pp. 974 - 996.

McGrath, R. G. 1999. Falling forward: real options reasoning and entrepreneurial failure. Academy of Management Review, Vol. 24 (1), pp. 13 - 30.

McGrath, R. G. & MacMillan, I. C. 2000. The Entrepreneurial Mindset: Strategies for Continuously Creating Opportunity in an Age of Uncertainty. Boston, MA: Harvard Business School Press.

Maingart, S., K. De Waele, M. Wright, K. Robbie, P. Desbrieres, H.J. Sapienza, A. Beekman, 2002, “Determinants of required return in venture capital investments: a five country study” Journal of Business Venturing 17: 291-312

Mason, C.M. and R.T. Harrison, 2002, “Is it worth it? The rates of return from informal venture capital investments” Journal of Business Venturing 17: 211-236

Nonaka, I. 1994. A dynamic theory of organizational knowledge creation. Organizational Science, Vol. 5 (1), pp. 14 - 37.

Nonaka, I. 1998. The concept of “Ba”: Building a fountain for knowledge creation. California Management Review, Vol. 40 (3), pp. 40 - 54.

Pagno, M. and A. Roell (1966) “Transparency and Liquidity: A comparison of Auction and Dealer markets with Informed Trading” Journal of Finance vol 51(2): 579-611

Powell, W. W. 1990. Hybrid organizational arrangements: New forms of transitional arrangements. California Management Review, Vol. 30 (1), pp. 67 - 87.

Ring, P. S. & van de Ven, A. H. 1992. Structuring co-operative relationships between organizations. Strategic Management Journal, Vol. 13 (7), pp. 483 - 98.

Sanchez, R. (1993) Strategic flexibility, firm organization, and managerial work in dynamic markets: A strategic options perspective. Advances in Strategic Management, Vol. 9: 251 - 91.

Schumpeter, J. 1943. Capitalism, Socialism & Democracy, London: Unwin University.

Stuart, T. E., H. Hoang and R.C. Hybels, 1999, “Interorganizational Endorsements and the Performance of Entrepreneurial Ventures” Administrative Science Quarterly 44: 315,

Teece, D. J. 1984. Economic analysis and strategic management. California Management Review, Vol. 26 (3), pp. 87 - 110.

Teece, D. J. 1996. Firm organization, industrial structure, and technological innovation. Journal of Economic Behaviour and Organization, Vol. 31 (2), pp. 193 - 224.

Tirole, J. 1988. The Theory of Industrial Organization, Cambridge, MA: MIT Press.

Trigeorgis, L. 1999. Real Options: Managerial Flexibility and Strategy in Resource Allocation. Cambridge, MA: MIT Press.

Von Hippel, E. 1986. Lead users: A source of novel product concepts. Management Science, Vol. 32 (July).

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.



Return to Top



 

Home ] Hilliards Bio ] Contact ]

Copyright © 2004 Bill Hilliard