When choosing how to manage your investment strategy, every investor is struck with a wide choice of different investment vehicles on the market. Average investors will likely opt to invest in mutual funds, or ETFs, but accredited investors who like to take on some risk will prefer other alternative investment options. Then often pops up the question - venture capital vs hedge fund.
Hedge funds are more risky and diverse investment vehicles, that can even include venture capital investments. They prefer to take the risky road and bet to generate high returns. Beating the index and generating alpha is their main goal. Venture capital funds are focused on venture investment strategy. They invest in young private companies in different stages of development. This approach also comes with a risk, but in the case of a success it can deliver massive long-term gains.
To identify the best investing approach for you, we will go through these forms of investments, discuss their similarities and differences, how they manage their investments, and what investors can expect to achieve. This is going to be an interesting piece, so stay with us!
Key Takeaways
- Hedge funds offer an investment platform with a prime way to diversify the portfolio through investing in different asset classes. On the other hand, venture capital is focused on investing in start-ups and young companies.
- These investment vehicles share a similar investor base. Only accredited investors can place their capital into these investment opportunities.
- Hedge funds offer both short and long-term strategies. Venture Capital is exclusively a long-term investment.
- Both can deliver exceptional returns but also can fail in a grand manner. Startups can fail, just like a sudden market shift can destroy entire hedge fund portfolios.
Definition Of Venture Capital
Venture capital funds are a form of private equity financing that provides capital to early-stage companies that show high innovative or growth potential. The main goal of venture capital management is to identify potential lucrative start-ups and commit to them. This is typically a long-term investment because it takes time and effort to move from a small start-up to a growing and profitable company.
Venture capital firms often have an industry sector they prefer to invest in. There are companies that sponsor start-ups from the healthcare sector, while others move to tech or AI. Also, amongst them, there are ventures that can spot a good story from any sector.
Investing in Venture Capital comes with several types of risks. The first is that investing in start-ups is usually illiquid. Once a company places their investments they have to wait for a prolonged 5 to 10 year period to earn a gain. That usually comes after the company is sold, or goes IPO.
While opting for these often highly innovative young companies can be tempting, a lot of them do not make it. The product or service doesn't play out like it was planned, even with capital backing it. That is another risk that venture capitalists take.
Other factors that impact the sustainability of venture capital investment are the quality of the management team of startups, industry volatility that can devalue the investment or a strong competitive landscape.
Definition Of Hedge Funds
Hedge funds are pooled investment vehicles that offer a diverse group of strategies to generate gains. What sets it apart from other financial instruments is that it is always seeking to beat the market regardless of its direction.
Hedge funds in the beginning utilized one strategy - long/short equity, which is still very popular. Over time it introduced several others, like global macro, event-driven, distressed debt, merger arbitrage, and high-frequency trading. By offering various approaches hedge funds were able to offer something to almost every investor.
Hedge funds invest in a wide pool of assets. Depending on the fund and its strategy they can move into the private equity market, publicly traded companies, commodities, materials, debt, distressed assets, or real estate. The sheer number of combinations is huge. This diversity that they offer is one of the selling points of hedge funds.
Due to the high risks that come with hedge fund investing, hedge fund managers need to incorporate risk management as a part of their strategies. It comes in a combination with due diligence and allows managers to assess their investment target in depth, before making an actual investing decision.
Throughout history, hedge funds often draw shady characters to their investor base, due to lack of regulatory scrutiny. One of the issues that the wider public has with hedge funds is that they can choose what to share with their investors. Lack of transparency and often long lock-up periods are factors that are pushing away potential investors.
Investor Base And Accessibility
We can put venture capital and hedge funds in the same base regarding questions of investor base and accessibility. Both of these vehicles are deemed advanced and risky, and thus retail investors do not have access to them.
To be able to invest in either of these investment vehicles, an investor needs to be accredited. What does that mean? In reality, accredited investors must pass a financial or professional threshold that would allow them to invest their capital.
Regarding types of investors, both venture capital and hedge funds draw similar groups. Those are either high net worth individuals or institutions. Pension funds, endowments, fund of funds, and similar investment vehicles all aim to diversify their portfolio through investing in these vehicles.
If we are solely looking at financial conditions, an accredited investor must have an annual income of at least $200.000 ($300.000 if married), or a $1 million net worth. If not, he must have an investing background and possess some of the certificates like Licensed General Securities Representative (Series 7, 65, 82). Essentially holders of these licenses either can sell a broad range of securities, or provide investment pieces of advice to investors.
Structure And Organization
Hedge funds in the United States are organized as either Limited Partnerships or Limited Liability Companies. Limited partnerships divide the responsibility between the general partner and limited partners. A general partner manages the fund and makes investment decisions, while limited partners provide capital and do not make crucial business decisions.
In an LLC organizational structure members share profit and losses depending on their share in the company. Decision-making is divided amongst members, and usually, all have a say in the investment decision process.
On the other hand, Venture Capital firms are mostly organized as Limited Partnerships. The organizational structure is the same as that of hedge funds with the same organizational structure.
Venture Capital vs Hedge Funds: Investment Strategies
Venture Capital
Choosing the stage in a company's life is the main diversification element for venture capital investing. Some firms invest in seed-stage companies, that are in the first stages of development. This type of investing focuses on finding a product or service, a marketing strategy, and team construction.
Investments into start-ups that have a service or a product and are in the starting stage of acquiring capital are called early-stage investments. This is also a common venture capital strategy that is used when a company wants something concrete to stand behind.
Next in the pecking order in venture capital firm investing is the growth stage of the company. This is a stage of the development of the company when it already has some success and a solid market position. However, to proceed, and increase their revenue they need an influx of fresh capital that can, among others, come from venture capital funds.
Finally, there are venture capital funds that prefer to invest in late-stage companies that are closer to an IPO or an acquisition. When compared to the three investment stages before, this comes with the lowest risk rate. The company is already up and running, it has its market share, and it needs the capital that can ensure a safe exit.
Hedge Funds
Hedge funds have a variety of strategies they can employ to get the highest returns. They are not bound by any regulation on how will they implement the strategies. They can use multiple strategies, or specialize in one.
Long/short equity is the strategy most commonly connected with hedge funds. It gives the opportunity to hedge fund managers to generate positive returns from both ends of the market. They invest in the long term in companies that show potential for growth. At the same time, they pick companies that are in the downturn trend and place a short-term bet that their stocks will lose value.
Another frequently used strategy is global macro. Essentially managers are on the lookout for a potential global event that can push markets into a certain direction. An event can impact a local market, a company, or an entire industry sector. Managers with experience can make their decisions at the right time, choose the right side to invest in, and profit from it.
An event-driven strategy relies on investing in companies that are undergoing a major event, or a special situation that can trigger a price fluctuation. If managers have information about imminent crucial events like a merger, restructuring, or bankruptcy, they can take on this high-risk bet to make a profit. Often hedge funds in these situations take an active role in company operations, with the intention to see the company pull through and get the best out of the process.
Hedge funds that opt to invest in high-risk distressed debt, are another subgroup of hedge funds. They are on the lookout for companies undergoing bankruptcy or restructuring and have a lot of debt willing to sell. Funds aim to buy this debt at a discount, and later resell it in case the company bounces back.
Investment Goals
Venture Capital Investors
Depending on the firm, its strategy, approach, and culture, there will be differences in investment goals. The crucial purpose of venture capital investing is high growth potential. By investing in still rather underdeveloped companies, venture capitalists have the potential to own significant stakes in a company that can become highly innovative and profitable down the road.
Often ventures aim for startup companies in the early stages which can develop disruptive technologies that often lead to major market positions and competitive advantages. These companies in developing stages have the potential to scale their operations.
Venture capital firms raise capital for young companies in development while focusing on the long-term investment horizon. When are companies small and underdeveloped they are very cheap, and during the growth stage, and while nearing their initial public offering, their value can multiply. This scenario can bring massive returns to venture capitalists that are often higher than potential investment risk.
Besides purely economic factors and benefits, venture capital firms invest also so that a potentially great and innovative idea can get financial backing. There were so many ideas that flew under the radar because no one either saw them or didn't want to risk the investment. That is why venture capital firms play a major role as a financial instrument.
Hedge Funds
Hedge funds utilize various financial instruments for only one purpose - to generate absolute returns no matter the market orientation. Hedge fund strategies can adapt to different market trends and exploit them for profits.
Unlike mutual funds, ETFs, VSs, and similar investment vehicles, hedge funds are willing to take on significant risks to beat the market, and generate alpha. Another goal is capital preservation, or keeping the capital intact from significant losses. To achieve this hedge funds employ risk mitigating strategies, including position hedgings, stop-loss orders, etc.
Hedge funds are often considered as an investment vehicle that provides diversification of investor's portfolios. Through their often wide sector and geographical exposure is a goal itself that brings potential for less exposure to risk, and potentially higher gains.
Closing Remarks
Investors who are pondering about investing in hedge funds or venture capital are often comfortable with higher risks. These investment vehicles are known for their bold bets that no one other would take. While these risks can come with high rewards, potential investors must be aware of the issue with liquidity.
While hedge funds can provide a certain level of liquidity, venture capital is an investment that you forget about for at least five years. If you are a long-term horizon investor, you can also find good options in the hedge fund category. But, if you are more of a diversified investor type, opting for a hedge fund could be a better option for you.
No matter what decision you make, do not forget about due diligence. You are placing your capital into someone's care, and you need to be sure that you have matching goals and ethical standpoints. Wage the benefits and downsides, and do not be afraid to ask for a bit of advice. Careful evaluation will do you a ton of good in the long term.