Venture debt firms aren’t happy that hedge funds are encroaching on their turf by lending to high-tech startups.

October 19, 2005

Venture debt firms on Wednesday blasted hedge funds that are seeking to lend money to startups, saying the funds often dole out ill-advised loans to companies that may not be able to return the money.

Venture debt firms, such as Silicon Valley Bank and Sand Hill Capital, make money by loaning money to startups to help them expand their operations without diluting ownership.

But increasingly, hedge funds have also become interested in venture debt opportunities that can yield returns between 9 and 12 percent. Hedge funds such as Ritchie Capital Management have set up special funds exclusively for venture lending.

Tom Vertin, a division manager at Silicon Valley Bank, told the crowd gathered at the ThinkEquity technology and investor conference in Half Moon Bay, California, he fears hedge funds in the short term will make poor investment decisions.

“There will be something to correct that,” said Mr. Vertin. “It’s unsustainable.”

More startups are turning to venture debt firms as they allow the startups to get cash without having to give up shares of stock. The only catch is that they are on the hook to pay off the loan (see Going Into Debt).

Typically, when a startup takes on equity investment—the specialty of venture capital firms like Kleiner Perkins Caufield & Byers and Draper Fisher Jurvetson—it has to give up some of its equity for cash.

More venture debt has become available for startups to call upon with the arrival on the scene of hedge funds. But for venture debt firms, the hedge funds mean competition in an area where there once was very little. And venture debt specialists raised concerns about the new kids on the block.

“The abundance of debt available—we made an estimate that there’s $1 billion out there that wasn’t there 18 months ago—is driving deals down to structure and price,” said Mr. Vertin, referring to the fact that venture debt firms are having to offer more competitive loans.

Growing Hedge Fund Interest

Hedge funds have changed their structure to be able to make more venture debt loans, said Christopher Barber, a managing director of Sand Hill Capital. Among the changes, they have relaxed liquidity requirements.

“They used to have quarterly capital calls,” said Mr. Barber. “But hedge funds have increased their allotment for alternative asset classes. That’s giving hedge funds the opportunity to invest in these illiquid assets, like debt.”

Among the signs that hedge funds are getting more serious about the potential, Ritchie Capital Management hired Bill DeMars and other members of GE Commercial Finance to run a $200-million fund announced at the end of September (see Hedge Fund Jumps into Venture Debt Investing).

Some startups are seeking out hedge funds to lend them money. Pay By Touch was one of them. John Rogers, the biometric payment startup’s founder, didn’t want to lose control by selling more of the company’s equity.

“John had talked with four different Investment Banks and they said it couldn’t be done,” said Pay By Touch VP Gus Spanos.

So the startup turned to hedge funds. Och-Ziff Capital Management led a $75-million debt financing with help from Farallon Capital Management and Plainfield Asset Management earlier this month. Pay By Touch also raised $55 million in convertible promissory notes, which can be turned into shares when the company prices its third round of financing.

“It was clear to me that the hedge fund community would understand this structure better,” said Mr. Spanos.

Mr. Spanos said hedge funds are doing a lot of private company investing and have a history of sophisticated deal structures.

“They were very receptive to structuring something with debt that had a small component of equity that was more compatible to our interests than what we could find in the plain-vanilla venture community,” he said.

Venture Debt Firms Predict Problems

But executives at traditional venture debt firms made dire predictions about hedge fund involvement at the conference.

“When things are going swimmingly well, the cheapest capital is the best,” said Mr. Barber. “It’s not sustainable. For a lot of these deals, you can look under the hood and see the company isn’t going to have returns.”

Silicon Valley Bank’s Mr. Vertin predicted interest from hedge funds would subside when it came time to count the returns.

“The limited partners won’t get their returns and won’t invest again,” he said.