Private Fund Round-up

Writing on the wall for hedge funds?

In a paper entitled How Important Are Hedge Funds in a Crisis?, a German economist by the name of Reint Gropp challenged the notion that hedge funds played an insignificant role in the global financial meltdown of 2007-9.  Professor Gropp contends that hedge funds were actually more instrumental than commercial or investment banks in spreading the risks created during the crisis and should therefore be considered systemically important financial institutions under Dodd-Frank.  His paper was just published by the San Francisco Federal Reserve where Gropp is currently a visiting scholar.  

Gropp’s model measures the spillover effects of financial crises among commercial banks, investment banks, insurance companies and hedge funds.  He claims the stresses due to linkages among the institutions are significantly underestimated in widely used risk measures such as value-at-risk.  He also points out that spillovers are typically measured as correlations among the returns of different asset classes, which do not identify the directions risks travel between assets.

Not surprisingly, Gropp’s analysis found that financial crises amplify the spillover effects among financial institutions compared with normal times.  The surprising finding, however, is that hedge funds – which have up to now avoided any responsibility for the crisis — are the most important transmitters of shocks during periods of market turbulence, even more important than commercial banks or investment banks.  Insurance companies apparently spread the least distress among financial institutions in both normal times and financial crises (notwithstanding isolated cases like AIG).  

Gropp claims that leverage is behind the financial shocks that hedge funds cause other financial institutions.  If funds are forced to liquidate assets at fire-sale prices, they may not only default on their counterparties and creditors, but their forced sales will also depress the valuations of those assets held by other financial institutions leading to further defaults and losses.

Stay tuned: we may soon see hedge funds in Basel.

Preserving control over start-ups seeking venture capital

Since everyone wants to be a start-up nowadays, those hoping to eventually attract venture capital should prepare in advance for the negotiations with VCs over management of their companies.  Before giving up equity or issuing convertible notes in exchange for cash, entrepreneurs should focus on how to preserve control over their babies.

To counter what will be their diminished ownership, entrepreneurs can, in their formation documents, grant themselves a class of common stock carrying special voting rights and governance protections.  

“Entrepreneur’s shares” (or “Class E” shares) can look a lot like preferred stock.  For example, the founders could require a majority vote of Class E shares for any of the following undertakings:

  • amending the Certificate of Incorporation or by-laws
  • forming or disposing of a subsidiary
  • changing the size of the board of directors
  • creating an additional class or series of capital stock
  • changing the authorized number of shares of any class or series of capital stock
  • liquidating or merging the company

Class E stock could also permit its holders to permanently control a majority of the board or require a unanimous vote of the Class E board appointees for the company to make other important decisions, such as amending its stock option plan or issuing debt securities. 

The one by-law practitioners counsel against is across-the-board “super-voting” privileges for founders.  10-1 voting rights on all matters, for example, are generally unacceptable to VCs who typically expect all shares to carry equal voting rights even if they are willing to vest ultimate control of the company in the founders.

Financing women entrepreneurs in developing countries 

Goldman Sachs and the World Bank recently launched a $600 million fund designed to spur lending to business start-ups founded by women entrepreneurs in developing countries.  The goal is to reach as many as 100,000 women-owned start-ups.   Goldman has seeded the fund with $50 million and the World Bank $100 million, with the balance to come from public and private co-investors. 

After years of supporting business training programs for women entrepreneurs around the world, Goldman learned that the biggest obstacle women face in growing their small and medium-sized businesses is lack of access to capital.  The World Bank estimates that 70% of women-owned SMEs in developing countries can’t get business loans.  The result is an estimated $285 billion global shortfall in credit available to women entrepreneurs.  

The new fund will extend lines of credit and share risk with local banks in developing countries enabling them to on-lend to women-owned SMEs.  The backstops provided by the fund will be specifically designed to break down the barriers inhibiting local banks from extending credit to women entrepreneurs in their respective markets. 

A recent Goldman research report on the financial impact of increasing female access to capital in emerging economies concluded that closing their credit gaps could increase their per capita incomes by an average of 12% and by more than 25% in developing countries such as Brazil and Vietnam where the  gaps are widest.