Table of Contents
What is venture capital?
What are hedge funds?
VCs vs. hedge funds
The bottom line
Jun 27, 2022
7 min read
Both are formidable forces in the capital markets. They are focused on generating profits, but diverge in the allocation of money, the two can serve as complementary styles.
Both venture capital and hedge funds are classified as alternative asset classes because they are very different from publicly traded stocks, bonds, cash, or commodities. Although venture capital and hedge funds operate in different parts of the financial markets, they use similar legal and fee structures and are both lightly regulated by the government.
Venture capital (VC) provides equity financing to young, private companies with attractive growth prospects. Hedge funds, on the other hand, mostly invest in publicly traded securities like stocks, bonds, and other financial instruments such as derivatives. A defining characteristic of hedge funds is that they use borrowed money and tend to wager both for and against securities, from which derives the term hedge.
provide the capital necessary for startups to grow in exchange for equity stakes in the business. Their money mostly comes from institutions like pensions, endowments, and foundations who serve as limited partners, or LPs, in the specialized partnerships or funds that VCs manage.
VC firms also often provide technological, financial, and management advice to the startups they invest in and may have representatives on their boards. There are nearly 2,000 VC firms, including well-known ones such as Silver Lake, Sequoia Capital, and Kleiner Perkins, which control their funds through general partnerships.
The time frame of these specialized partnerships is usually between 7 to 10 years, during which time the investors’ money is effectively locked up in the fund—that is, unable to be withdrawn.
VC investors can harvest profits either when the startup is acquired by a bigger, established company, or when the company goes public in an initial public offering, or IPO. Alternatively, the firm and the LPs can sell part or all of their holdings to another VC firm or institutional investor before either of these exits.
A handful of VC firms have recognized huge returns from investing in successes like Apple, Intel, and Amazon. But there is a substantial amount of losses incurred on the vast majority of VC investments. The National Venture Capital Association estimates that 25% to 30% of all VC investments fail, while up to 40% only return their investors’ original capital. Another estimate puts the failure rate at 75%.
Returns, on average, have beat the market, though. Research firmCambridge Associates calculates that U.S. venture capital returns averaged 10.9% annualized for the 20-year span ended Sept. 30, 2021. That is only slightly more than the roughly 10% average annual historical return of the Standard & Poor’s 500 Index.
are also largely funded by institutional investors and have similar legal and fee structures as VCs. But hedge funds invest mostly in publicly traded instruments—typically stocks, bonds, and futures.
There are more than 10,000 U.S. hedge funds and they utilize a wide range of strategies. One tactic most every hedge fund employs to some degree is short-selling—or wagering that a security will fall in value. Usually that means borrowing a security for a fee, selling it, and then buying the same number of shares when the price of the security falls to repay the lender, locking in a profit.
Hedge funds fall into one of four overarching investment strategies:
Sometimes called “equity hedge,” these funds might buy PepsiCo stock and short Coca-Cola shares.
Managers identify mispricings between related securities like bonds, often issued by a single company. A manager might buy 20-year General Motors bonds, for example, and sell short the company’s 5-year bonds. The hedge fund will likely make a profit as long as the 20-year bond appreciates more than its shorter-term counterpart.
These make bets anticipating corporate developments such as quarterly earnings surprises, mergers, restructurings, and dividend hikes. They can balance out bullish bets on anticipated positive developments by hedging with a short wager on an industry-focused exchange traded fund, or ETF.
Sometimes called macro funds, these bet on global economic trends including by investing in other nations’ sovereign bonds or currencies, typically in the futures markets. If the price of oil falls, for example, it might be time to wager against the Norwegian kroner, which benefits from higher oil prices while buying the sovereign bonds of Germany, whose economy benefits from lower energy prices.
Within these broad categories are myriad other strategies. These include dedicated short-selling to convertible arbitrage to systematic quantitative, whose computer-based algorithms use formidable data processing power to identify trends or price anomalies in hundreds of markets and attempt to profit from them, often by the second.
While investing, hedge fund managers almost always use leverage, or borrowed money, to amplify returns. Leverage, however, is a double-edged sword: It might magnify gains, but it can also be deadly if markets go awry.
In 1999, for example, a prominent global macro hedge fund called Long-Term Capital Management LP—whose management included Nobel Prize-winning economists—borrowed $50 for every $1 it invested. When its bond market forecasts proved wrong, it couldn’t pay its debts, and the fund collapsed, requiring a massive, government-orchestrated Wall Street rescue.
For the 31 years from 1990 to 2021, the HFRI Institutional Fund Weighted Composite Index, which tracks thousands of hedge funds, returned 10.37% annually on average, according to Chicago-based Hedge Fund Research, which tracks the industry. The HFRI Index lost money in only five of those years, most notably in 2008 when the index plummeted 19%, about half the 37% loss of the Standard & Poor’s 500 Index that year.
VC firms and hedge funds differ in some essential ways, including how they raise money, their investing, and exit strategies.
Both VC firms and hedge fund firms raise money largely from institutions like pensions, endowments, foundations, and high-net-worth individuals. VCs, however, are more likely to engage personally with potential investors, given the long lockup periods for their investments. Large hedge funds, by contrast, often employ sales and marketing teams to raise funds.
VCs invest for the long term. Hedge funds trade, often second-by-second, and are focused on monthly, quarterly, and annual returns. It’s worth noting that some technology-focused hedge funds are increasingly dabbling in VC-style investments.
Each charges an annual management fee of 2% of assets under management, and also 20% of any profits—known as a performance fee or “carried interest.” Hedge fund fees often include a “high water mark” component: Before earning the carried interest, a fund’s net asset value must surpass any previous calendar year end’s value. So hedge fund managers are highly incentivized to generate continuous gains year-after-year. Also, the carried interest sometimes kicks in only after gains surpass a hurdle rate tied to a benchmark like the 30-year Treasury bond.
VCs often have a deep grasp of granular industry dynamics and the track record of a startup’s executive team, so they do their due diligence to determine whether an entrepreneur is the next Steve Jobs. Hedge fund managers and their associates, by contrast, require a nuanced grasp of the many markets in which they operate but don’t necessarily have to go as deep into any one specific startup.
The VC industry largely targets the technology and biotech sectors. Most hedge funds, but not all, are more general in where they invest. Both types of funds consult outside experts for advice, many of whom are former top industry executives with decades of experience.
A big difference between VC and hedge funds is the ability of investors to exit. Investors in a VC fund typically wait 7 to 10 years for the VC to wind down the fund so they can access their invested capital. Investors in hedge funds, by contrast, are generally allowed to withdraw their capital on a monthly, quarterly, or annual basis, although they may have to notify the fund in advance.
Both venture capital and hedge funds are formidable forces in the world’s capital markets. Though each is equally focused on generating profits, their divergent approaches to the allocation of money serves different purposes in the economy: Hedge funds typically make short-term investments while VCs take long-term stakes. For prospective investors, the two sometimes opposite stances can serve as complementary styles.
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