Why This Hedge Fund Sued Theranos

Well that was quick. No sooner had Theranos announced a major change in strategy, one of its biggest investors sued the embattled Silicon Valley startup and its infamous CEO, Elizabeth Holmes, alleging the company lied about the extent of its technology and committed securities fraud.

What’s interesting about the story, which was reported by the Wall Street Journal, is that the investor is not a venture capital firm but a Bay Area hedge fund: Partner Fund Management LP (PFM) invested $96 million in Theranos in February 2014, back when the company was valued at around $9 billion.

Perhaps the most unique characteristic of the recent private equity bubble that created hundreds of highly valued unicorns like Uber, Airbnb, Snapchat and Theranos is the prevalence of late-stage mega-rounds of funding that have taken the place of IPOs.

Many of those $100 million-plus rounds have been led by corporations like Google (NASDAQ:GOOGL), institutional investors like Fidelity, and hedge funds like PFM, as opposed to traditional VC firms. And it’s not at all clear that the latter have the wherewithal to perform the necessary due diligence and risk assessment to make those investments pay off.

Considering how much venture capital flows into startups every year ($129 billion globally in 2015, according to research firm CB Insights), suits of this nature are rare events. There’s a very good reason for that. Startups that go bust rarely have much capital left to reimburse investors. So VC firms employ teams of analysts and attorneys in robust due diligence processes.

In addition, VC firms tend to limit their investments to specific industries and types of rounds where they have deep expertise, knowing full well that, if the company goes south, so does their investment. And since a venture fund usually backs dozens of startups, most of which flop, it only takes a few big exits – acquisitions or IPOs – for them to pay off nicely.

Hedge Funds, on the other hand, are more adept at investing in public companies where the potential reward is not nearly as big but neither is the downside risk. So when a company like PFM invests big bucks in just a few startups, there is a distinct possibility that none of them will pay off, meaning they may lose the vast majority of their investment.

It’s worth noting that, according to the Journal, Holmes and then COO Sunny Balwani began pitching PFM in December 2013 and the deal closed on February 4, 2014. That’s a very short timeframe as funding rounds go – hardly long enough for deep due diligence. Not to mention that nearly $100 million at a $9 billion valuation is a lot of capital for a nominal stake that doesn’t even include a board position. That sort of thing was unheard of before this private equity gold rush.

Which brings us to the suit. Considering the extreme sanctions by federal regulators that led Theranos to abandon its core strategy and exit the lab testing business, not to mention the voiding of years of blood test results, investigations by the SEC and FBI, and several class-action suites, you would think the case would have merit.

Theranos seems to have misled everyone from patients and the media to big partners like Walgreens (NYSE:WBA)and Safeway, so the notion that its executives may also have misled investors is not very far-fetched. That said, even if PFM wins the suit, the chances of recovering a material portion of its investment is, in my view, relatively small.

As a practical matter, by the time the complaint works its way through the court system, Theranos will have either succeeded or failed in its new plan of developing a miniLab platform. In the unlikely event that it succeeds, PFM’s investment might very well pay off, making the suit moot. And if Theranos fails, creditors are likely to get pennies on the dollar. So what’s the point?

I think the hedge fund sued to cover its behind with its partners when it never should have been writing nearly nine-figure checks to a high-risk startup in the first place. It’s telling that very little of the $800 million or so Theranos raised came from traditional VC firms. The vast majority came from an odd assortment of corporate, family and other crossover funds. The smart money sat on the sidelines. That should have been a sign.

It’s also interesting to note that global deal activity and mega-rounds fell off a cliff in the fourth quarter of 2015 and have been on the decline ever since. The bubble isn’t quite bursting, but it is deflating. Considering the preponderance of non-VC investors that fueled the private equity hysteria, I think we’re going to see a lot more of these types of suits in the coming years. Probably more against Theranos, as well.