Hedge Funds - Venture Capital
The very profitable hedge fund industry has recently shown more than a passing interest in venture capital investments. Hedge funds have a few advantages in direct hedge fund vs. venture capital competition.
A hedge fund is an investment vehicle that is really a bit difficult to define and understand. It differs from a mutual fund and other more regulated funds mainly by its lack of regulation. This freedom comes from the fact that it open to only accredited investors rather than the general public. The idea here is that since hedge funds are not really “public” offerings in the same manner as mutual funds, investor protection by outside regulation is not imperative. Recently, hedge funds have made some inroads into venture capital investing, mainly in the area of latter stage investments.
The hedge fund gets its name from the fact that it originally hedged most of its investments to insulate it from potential loss. Their portfolios were very diversified and they used tactics such as short selling to further reduce risk. Recently, two major trends have developed with hedge funds. One is that they do not always hedge investments and sometimes use their tactics, such as short selling, to increase risk while also increasing rate of return. The hedge funds have reached a point where they control billions of dollars of investment capital and are looking for new places to invest it.
The baseline fee structure in the venture capital industry is know as 2 and 20. This is a 2% management fee and 20% of the profits. The 20% is generally known as “the carry.” Some of the better firms get 3% management fees and a 30% carry. Since venture capitalist invest time in management there is a direct correlation between the assets under control and the number of partners or VC managers in the firm. This means that growth in a venture capital fund tends to dilute the individual share of carry going to each partner.
The hedge fund managers, on the other hand, do not become actively involved in the majority of their investment from a managerial standpoint. This allows them to control more investments. The baseline fee structure is much more flexible for them with some firms taking a 50% carry and no management fees at all. The extremely high amount of capital available for investment in the hedge fund industry means that what would be a minor, almost unnoticeable move into venture capital for them would have a major impact on the smaller venture capital market.
Hedge funds and venture capital funds really have different goals and operating procedures and represent what should be two separate investment industries. It is the large amount of capital that is being controlled by the hedge funds and a dearth of really profitable placements for it that has brought venture capital to its attention. The entry of hedge funds into the venture capital market should be a cause for concern and attention.