Charles “Chase” Coleman III is the quintessential hedge fund trader. Like many of the industry’s top managers, Coleman learned to bet on stocks as a protégé of hedge fund legend Julian Robertson. But Coleman’s Tiger Global Management, a New York firm with $10 billion under management, has also mastered another strategy.
Coleman was way ahead of U.S. investors when Chinese software firm Longtop Financial Technologies began trading on the New York Stock Exchange in October 2007, leaping 85% to $32 the day of its IPO amid a frenzy for emerging markets technology stocks. Coleman had amassed an 18% stake in Longtop two years before for less than $5 a share. He was one step ahead of other investors again when he began selling, unloading almost 8 million Longtop shares by the end of 2010. The stock ultimately became worthless, but Coleman netted at least $100 million in profits on his $46 million initial investment.
Investors in Longtop’s IPO didn’t fare so well. Longtop shares rose as high as $41 after its IPO price of $17.50, then plunged after short-sellers questioned the company’s finances and the Securities & Exchange Commission launched an investigation into what the company’s own accountants labeled possible “illegal acts.”
Coleman, 36, declined to comment. His firm isn’t implicated in the alleged fraud, which came to light in 2011, despite having a representative on Longtop’s board until May 2009. But the trade illustrates how some investment titans are getting rich these days, even off of loser stocks. They scoop up shares in advance of public offerings and then reap huge profits as firms gain momentum as hot venture-backed startups and ultimately public companies. Coleman, who ranks as No. 6 on our annual Top-Earning Hedge Fund Managers list with $500 million in 2011 earnings, owns big stakes in Facebook and LinkedIn.
Hedge fund managers can thank Congress and the SEC for the opportunity. Some call it “regulatory arbitrage”: well-meaning but inherently flawed laws such as Sarbanes-Oxley that were designed to protect small investors from the next Enron have imposed such heavy costs on public companies that many private ones are delaying their initial public offerings. Venture capitalists, employees and early investors who want to sell out have little choice but to sell their shares to lightly regulated funds, which can buy stock in the next IPO at a steep discount to what retail investors ultimately will pay.
“This market is growing, and hedge funds want a piece of the action,” says Jose Miguel Mendoza, a corporate law lecturer at Oxford University studying pre-IPO investing.
Initial public offerings in the U.S. have dropped to around 100 a year from more than 300 a year between 1980 and 2000, according to University of Florida professor Jay Ritter. Some of that can be blamed on the economy and markets. But Sarbox and other investor-protection measures have made it prohibitively expensive to go public, especially for small companies.
“Companies are choosing not to go public in the rapid-growth stage because it’s extremely burdensome,” says Greg Brogger, the president of SharesPost, an online trading platform for pre-IPO shares. Thus, there’s no way for retail investors to buy into the companies that used to drive small-cap returns on the Nasdaq market.
That leaves hedge funds and other sophisticated investors to fill the void. By the time Facebook filed for its IPO it had some 1,100 shareholders, including mutual fund giant T. Rowe Price, Goldman Sachs and Russian billionaire Yuri Milner’s DST Global, which spent less than $250 million assembling a 5.4% stake currently worth $5 billion. Sellers included early investors and employees like cofounder Eduardo Saverin, who sold shares to Milner in 2010.
Coleman amassed an estimated 1% pre-IPO stake in Facebook worth perhaps $1 billion, reportedly at a cost of less than $200 million. Partly through his $6 billion Tiger Global hedge fund, Coleman purchased 2.4 million shares of LinkedIn for an average price of $16.44 before its IPO price of $45, generating a $287 million gain after shares doubled to $94 on the opening day.
There’s so much pre-IPO stock sloshing around these days that companies such as New York’s SecondMarket and SharesPost run thriving online marketplaces to match buyers and sellers. SecondMarket says it brokered some $550 million in trades last year, almost 80% involving employee stock, and has 85,000 registered users on its online trading platform. Participation is limited to so-called qualified investors with more than $1 million in liquid assets and annual income in excess of $200,000. In total, $9.3 billion of private-company stock traded hands in 2011, according to Nyppex LLC.
Changes in Rule 144 governing private stock sales have fueled the growth of private exchanges because the “lockup period” in which investors must hold stock has fallen from three years down to one. Private stock trading has recently drawn the scrutiny of the SEC, which wrung an $80,000 settlement out of SharesPost for operating without a proper license. Brogger declined to comment.
Coleman often does his buying in specially formed funds that are registered as venture capital vehicles, like Tiger Global FB Partners, which raised $60.4 million in February 2011 to buy pre-IPO Facebook shares. His firm has a number of other SEC-registered funds it formed to buy shares in companies like LinkedIn and MakeMyTrip, a fast-growing online travel business in India.
Most retail investors have little chance of getting in on hot initial offerings, and studies have shown that a substantial part of positive IPO returns typically occur during the first-day “pop.” For every Google, which has risen 500% since its 2004 IPO, there are 20 similar to Pets.com, which languish or even shut down after they go public.
Hedge funds are also stepping into a market with a “high degree of information asymmetry,” says Oxford’s Mendoza, meaning the sellers know more about their companies than the buyers. In 2010 venture capitalists were responsible for most of the stock changing hands in pre-IPO markets, Mendoza says, but last year hedge funds bought 70%.
“The fact that hedge funds have overtaken VC funds might give some credence to the idea speculation” is driving the value of consumer Web stocks, he says.
Preppy Chase Coleman has made a specialty of buying into emerging markets firms that are destined for U.S. IPOs. With the assistance of lieutenants like Feroz Dewan, Coleman has steered Tiger Global Management into winners like MercadoLibre, an Argentinean e-commerce company. The firm bought 1.7 million shares before MercadoLibre’s IPO and gained an estimated $250 million by trading out of the position as the stock rose to $100. Coleman is likely to have made another $150 million on MakeMyTrip. He bought a 12% stake in 2007 and 2008 for $5 a share. The stock sells at $23 today.
Not all of Coleman’s pre-IPO bets have been winners. An investment in Chinese biodiesel company Gushan Environmental appears to be a loser. Gushan’s price has declined from $5 at its IPO to less than $1.50 today.
But Coleman’s big winners outweigh his losers. His firm’s largest publicly disclosed position is a $1 billion stake in Yandex, the Russian Google competitor. Despite the fact that the value of his stake has dropped by $900 million since its post-IPO peak, Coleman is still sitting on $1 billion in unrealized gains. Score another one for the smart money.