Clients want a piece of Facebook? Try derivatives fund

Demand for shares in privae social networking giant is giving rise to new type of investment asset; 'secondary transactions'

Nov 24, 2010 @ 8:21 am

Facebook Inc.'s surging valuation is spurring shareholders to slice and dice their stock, giving investors everywhere from Silicon Valley to Wall Street a chance to bet on the company.

EB Exchange Funds LLC, based in San Francisco, as well as New York firms Felix Investments LLC and GreenCrest Capital LLC, have opened Facebook funds for investors looking to get a piece of the social-networking company and its half-billion users.

By creating derivatives of the stock, the investment firms are helping Facebook keep its shareholder count at 499 or less, the maximum number a company can have before it has to disclose results to the public. They're also potentially creating a new class of assets for investors, letting them tap fast-growing private companies like Twitter Inc., Zynga Game Network Inc. and LinkedIn Corp. -- all valued in the billions of dollars.

“It's proving to be a really effective way for accredited investors to invest in private companies,” said Larry Albukerk, founder of EB Exchange Funds. “I don't necessarily know if it's a good investment or not -- I just know people want to invest and we provide a means for them to do that.”

Facebook, based in Palo Alto, California, has more than tripled in value since March to $40.7 billion, according to SharesPost Inc., an exchange for private companies. Zynga, the creator of online games such as “FarmVille” and “FrontierVille,” is worth $5.4 billion, and social-networking service Twitter is at $3.4 billion. SharesPost values professional-networking site LinkedIn at $2 billion.

Firm Founded

EB Exchange is buying as much as $15 million in Facebook shares for a limited liability company that's open to outside investors, according to a Nov. 1 letter to prospective shareholders obtained by Bloomberg. While Albukerk confirmed that he created the LLC entity, he declined to comment on whether it's investing in Facebook, citing regulatory restrictions that limit what he can say. A U.S. Securities and Exchange Commission filing from October says EB Exchange is raising $15 million for a “pooled investment fund.”

According to the investor letter, units in the LLC are offered in $10,000 multiples, with a minimum investment of $100,000. EB Exchange makes money by charging a 5 percent fee to enter the LLC and then another 5 percent when the shares are distributed after an initial public offering or acquisition. An LLC can have no more than 99 participants.

GreenCrest's Fund

Across the country in New York, Boaz Rahav, an 18-year veteran of the financial industry, founded GreenCrest earlier this year after talking to institutional investors who were having trouble finding a way to invest in Facebook. He expects to raise at least $100 million for his Facebook-specific fund.

“There are quite a large number of institutions, large and small, that missed the boat or missed the opportunity to invest in Facebook when Facebook was going through their capital- raising campaigns,” said Rahav, an Israeli who moved to the U.S. 15 years ago. “They're facing the challenges of identifying blocks of shares, negotiating a price and going through the negotiating process with Facebook.”

Jonathan Thaw, a Facebook spokesman, declined to comment. Albukerk and Rahav both said they eventually expect to open multiple company-specific LLC entities.

The trend is a concern for Laurence Allen, managing member of Nyppex LLC in Rye Brook, New York, because of the lack of transparency. For more than a decade, his firm has specialized in so-called secondary transactions -- deals that involve buying stock from existing shareholders, including employees. Primary transactions, by contrast, are investments from venture capitalists and other backers working directly with the company.

‘Less Discipline'

Because private-company financials are opaque, investors are buying based more on hype than actual knowledge about how the businesses are performing, Allen said.

“There's less discipline than in the typical investment process,” he said. “Firms like Facebook may have stupendous growth, a successful exit someday, and yet the investors in some of these funds may have overpaid so much that the returns are small and maybe even negative.”

Nyppex estimates that secondary-transaction volume for private companies will more than double this year to $4.9 billion. SecondMarket Inc., an online market for private companies, expects its volume to at least triple this year to $300 million to $400 million.

Opportunity to Sell

For Facebook, the emergence of the secondary market has enabled early employees and investors to sell all or part of their stakes, reducing pressure on the company to go public. Facebook is likely to put off its IPO until 2012, three people familiar with the matter said in July.

Felix Investments opened its first fund more than a year ago and now has them for 14 companies. The firm has two funds for each company -- one for investors with at least $1.5 million in liquid net worth, and the other for those with at least $5 million. Felix has raised about $250 million for the funds, said Frank Mazzola, a partner at the firm.

Similar to EB Exchange, Felix charges 5 percent upfront. It then takes 5 percent of the profit until an investment doubles. After that, it takes 10 percent. All of the investments are in fast-growing technology companies that are beyond the early stages, Mazzola said.

“The companies we're trying to get exposure to don't need money, don't want money, won't take money,” Mazzola said. “So how do you get exposure to them? It's by networking and finding some early employees and investors that have an interest in lightening up on some of their stock.”

Alex Bernstein, a San Francisco investor, bought a stake in EB Exchange's fund as part of a strategy to invest in private companies at various stages. While he's optimistic that Facebook's value will continue to rise, he recognizes the risk of investing in a pricey security that will be difficult to sell until the company goes public.

“It's an unproven path to liquidity and we're all hopeful that it will work out,” said Bernstein, who spent the past 18 years in investment banking. “Secondary markets play a meaningful role for a period of time. We still need an IPO window to get liquid.”

(--Bloomberg News--)_


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