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Both venture capital and hedge funds invest for big gains while accepting significant risk. However, there are some key differences between these two types of investments. Venture capital supports promising startups with the potential for exponential growth, while hedge funds take a broader approach and typically invest in a mix of stocks, bonds, commodities, and other assets. While small business owners usually engage with venture capital money rather than hedge funds, it can be helpful to understand how both of these investment vehicles work. Here’s a closer look at venture capital vs hedge funds.
What Are Hedge Funds?
Hedge funds use pooled money to invest in securities and other assets with the goal of producing positive returns. These funds are managed by professional fund managers who use a wide range of strategies, including leveraging or trading of nontraditional assets, to earn above-average investment returns. Because hedge funds are not as closely regulated as mutual funds, they have more freedom to pursue riskier investments that may increase the risk of losses. However, hedge funds usually also employ hedging strategies to reduce risk and maximize returns. For example, they may “hedge” their bets by investing a portion of assets in the opposite direction of the fund's focus to offset any losses in its core holdings.
How Hedge Funds Work
Hedge funds are managed by professional investors who often put their own capital into the fund. This gives outside investors confidence that the managers are equally interested in seeing the fund do well. Hedge fund managers typically receive an annual management fee, plus a performance fee. As a result, hedge fund fees and expenses can be significantly higher than mutual funds.Not anyone can invest in a hedge fund. These funds are typically only available to accredited investors (people with a high net worth who can afford the higher fees and risks of hedge fund investing) and institutional investors (such as pension funds).
Pros and Cons of Hedge Funds
For investors, hedge funds come with both advantages and disadvantages. Here’s a look at how they stack up.
Pros
Investment flexibility Hedge fund managers have more flexibility than mutual fund managers. As a result, they can use short selling, leverage, and derivatives, and invest across many asset classes.
Can be highly profitable Due to the fund’s freedom, managers can make high-risk bets with the potential for very high returns.
Diversification helps manage risk Managers typically diversify investments to reduce the fund’s exposure to any one type of investment strategy. This can help stabilize and improve returns.
Cons
Lack of transparency Since these funds are privately traded, hedge fund managers do not have the public disclosure requirements of publicly traded funds.
High fees These funds come with notoriously high management and performance-based fees.
Could lose your money If a manager over-leverages a fund or makes poor investment decisions, they can potentially wipe out the fund.
What Is Venture Capital
Venture capital (VC) is a form of private equity that funds startups and early-stage companies with significant potential for growth. These young companies sell ownership stakes to venture capital funds in exchange for financing, technical support, and operational expertise.Like hedge funds, venture capital funds are generally only available to institutional and accredited investors, such as high-net worth investors, large financial institutions, and pension funds.Recommended: Pre-Seed Funding vs Seed Funding
How Venture Capital Works
When a venture capital firm invests in fledgling businesses, they typically take an ownership stake of less than 50%. They generally then participate in the management of the startup to help drive growth. While the company’s founders may have expertise in their type of business, they may not have experience in growing a new company, which is something that venture capital investors can bring. Usually, a venture capital fund’s goal is to increase the value of the startup, then profitably exit the investment by either selling their stake or via an initial public offering (IPO).Many startups will turn to venture capital for funding because they are just starting out or have not yet turned a profit. Banks typically require an established track record and profitability to approve a loan. Venture capital investors, on the other hand, are willing to take on the risk that a company may fail for the chance of making a substantial profit if the company succeeds and goes public or another company acquires it.
Pros and Cons of Venture Capital
Venture capital comes with advantages and disadvantages — both for investors and for the businesses they invest in. Here’s a look at the pros and cons of venture capital from a business owner’s perspective.
Pros
Provides access to a large amount of capital Venture capitalists typically invest a significant amount of money into the companies in their portfolio, which can be helpful when you’re trying to launch a new business.
Expert guidance In addition to financial backing, venture capital investors often provide valuable guidance that can help you make key business decisions and grow your business. You’re unlikely to get this expert guidance from other types of investors.
Access to valuable connections. Venture capitalists are often well connected in the business community. Tapping their network could increase opportunities for your company and help you grow faster.
Cons
Can take a while to get funding It can take months (possibly years) to find the right venture capital firm and convince them to invest in your business. This could be frustrating if you’re eager to get your company off the ground as quickly as possible.
May lose some control over your business Venture capitalists may want to have a say in how you run your business, which could be a difficult adjustment if you are used to having total control over your venture.
High expectations Venture capitalists generally like to see a high return on their investments and will be expecting your business to grow rapidly and help them earn a substantial profit.
Here’s a look at the similarities and differences between hedge funds and venture capital funds.
Similarities Between Venture Capital vs Hedge Funds
Venture capital and hedge funds have several things in common. Both seek to earn outsized returns for their investors. And, with both, an investor could potentially lose money quickly if market conditions turn sour. In addition, both hedge funds and venture capital can tie up your money for a long period of time, potentially years. Also, you generally must be an accredited investor, which means having a minimum level of income or assets, in order to invest in either vehicle.
Differences Between Venture Capital vs Hedge Funds
While both hedge funds and venture capital seek profits, they use different strategies to achieve this goal. Hedge funds use a variety of investment strategies — such as investing with borrowed money, shorting stocks, or holding concentrated assets. Venture capital, on the other hand, generally focuses on investing in startups with potential for high growth. In addition, hedge funds can easily profit from a variety of market conditions, whereas a venture capital firm relies on strong growth from the companies in their portfolio.Finally, venture capital firms are hands-on with the businesses they invest in, whereas a hedge fund does not aim to influence how the companies they invest in are managed.
Alternatives to Venture Capital
Venture capital is one, but far from the only, way to raise capital to grow your small business. Here are some other funding options to consider.
Small Business Loans
You can use small business loans for a variety of purposes. Plus, you don’t have to relinquish any equity in your business as you would with venture capital funding. Once you pay back your loan, your relationship with the lender ends. With term loans, you receive a lump sum of money then pay it back (plus interest) in installments over a set period of time (the loan’s term). While banks prefer to work with companies that have been operating for at least two years, alternative online lenders tend to have more flexible requirements and will often extend credit to younger companies. However, their rates tend to be higher.Recommended: Startup Business Loans (Bad Credit and No Collateral)
Angel Investors
Finding an angel investor is another potential funding avenue for a new small business. Angel investors are typically high-net-worth individuals who offer financial backing for small startups, typically in exchange for ownership equity in the business. These investors differ from venture capitalists because they use their own money, rather than investing other people’s money. Angel investors also tend to supply smaller amounts of capital than venture capitalists. In addition, many have niche specialties that could align with your business’s industry or focus.
Business Lines of Credit
If you’re looking for flexible, short-term financing, you might consider getting a business line of credit. Similar to a credit card, a business line of credit allows you to withdraw funds as needed up to a predetermined amount and only pay interest on the money you withdraw. Once you repay the funds you’ve borrowed, you can continue to draw on the line. Business lines of credit are offered by banks and online lenders and can be secured (meaning you need to put up collateral) or unsecured (no collateral is required). If your business is new, you may not be able to qualify for an unsecured credit line, since they often require a solid financial history or strong business credit.
Compare Business Loan Rates With Lantern
If you’re looking to grow your business without giving up any equity, you may want to explore different types of small business loans, including term loans, Small Business Administration (SBA) loans, equipment financing, and lines of credit.If you’re curious about what rates and terms your business might qualify for, Lantern by SoFi can help. With our easy-to-use online lending tool, you can review and compare small business loans that meet your company’s needs and qualifications without any obligation and just one short application.
Frequently Asked Questions
Can hedge funds invest in venture capital funds?
Do hedge funds or venture capital funds make more money?
Is venture capital a bubble?
Photo credit: iStock/Andres Victorero
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About the Author
Mike Zaccardi
Mike Zaccardi, CFA, CMT, is a finance expert and writer specializing in investments, markets, personal finance, and retirement planning. He enjoys putting a narrative to complex financial data and concepts; analyzing stock market sectors, ETFs, economic data, and broad market conditions; and producing snackable content for various audiences.
