Let’s enter the wonderful universe of the hedge fund! The financial world is an intricate terrain, filled with various institutions and tools that just complicate things further. Moreover, new tools and structures are always bursting onto the scene. Consequently, when a financial institution operates in this world with secrecy and no oversight like hedge funds, it quickly garners a bad reputation.
Throughout this article, we will discuss what is a hedge fund. What does it do? What characteristics does a hedge fund have that makes it stand out from other financial institutions? And how can a hedge fund help start-ups?
What Is a Hedge Fund and What Does It Do?
To appreciate what is a hedge fund, let’s draw on a simple example:
Adam has some money saved up that he’d like to invest. However, investing is not an easy business, so Adam decides to entrust Luke to make his investment choices for him. In other words, Luke is going to manage Adam’s money in return for a small managerial fee as well as a performance fee. The management fee is what Luke gets for simply putting in the effort to manage Adam’s money, whereas the performance fee is the extra reward Luke gets for beating the market.
The usual structure out there is that the management fee is 2% of the assets that Luke controls, and the performance fee is 20% of the net profit. It’s called the 2 and 20 rule. Now, this payment structure is by no means the only possibility out there. There are several different ways Adam can reward Luke for managing his money. Finally, once Luke realizes that he is actually good at choosing good investments, Luke decides to take on more clients and pool their resources together. So, Luke ends up managing Adam’s money along with Sarah’s, Jeffrey’s and a few other people. Essentially, Luke just started a fund.
How can Luke use his hedge fund?
We can see that Luke has countless ways to invest his clients’ money. He can invest in different investment vehicles such as stocks, bonds, other funds, collateralized debts, real estate and so on. He can also leverage his investments so as to amplify his clients’ returns. Which is another way of saying that Luke can borrow money in order to increase his profits.
To illustrate this point further, let’s suppose that Luke has one million dollars to invest. If Luke makes a 15% profit for his clients at the end of the year, then that means that he made them 150,000 dollars. On the other hand, if Luke has one million dollars and borrows another million, bringing the grand total to two million, and still makes a 15% profit, he just made 300,000 dollars.
Luke also has several investing strategies from which to choose, such as developing a long/ short position or focusing on merger arbitrage. Each strategy has its own merits and cons. The main takeaway is that for any given strategy Luke has to try to balance between the amount of risk to which he exposes his clients versus the expected profits he can expect to make.
What makes a hedge fund different from other funds?
Although each hedge fund adopts a different strategy, there are several things that make hedge funds stand out when compared to other funds, like mutual funds. To start with, a hedge fund can invest in almost any tool or vehicle it chooses, whereas a mutual fund is usually more restricted to stocks and bonds, and a venture capital invests in start-ups.
Moreover, hedge funds tend to have leveraged positions. In addition, even though this isn’t how they started, hedge funds currently aim to maximize profits, making them risk seeking to a large degree. Finally, hedge funds cater exclusively to accredited investors. These are investors with a certain wealth, a high annual salary, and a sophistication that the common investor may lack. Another important point is that hedge funds aren’t regulated by the SEC (Securities and Exchange Commission).
In other words, a hedge fund can invest in whatever opportunity it chooses, without having to disclose that information to the public. Owing to the fact that hedge funds have a narrow niche and aren’t regulated, they don’t market themselves to the general public.
How Can It Help Start-ups:
The fact that hedge funds serve wealthy investors coupled with the fact that hedge funds are inclined to use borrowed money mean that they inject plenty of liquidity into the ecosystem. It was estimated in 2015 that hedge funds control up to 2.4 trillion dollars. Simply put, hedge funds aid start-ups by providing capital, both directly and indirectly.
Great Return Benefits
Some hedge funds lend directly to small and medium-sized businesses. A hedge fund’s willingness to take on risk for a higher expected return greatly benefits any business that needs capital.
Banks Work for You
Other hedge funds buy CDOs (collateralized debt obligations) from banks, which unburdens the banks, enabling them to lend more money. Let’s rephrase that: when a bank gives out a loan, it takes on the risk that the loaner might default. However, when a hedge fund buys that debt from the bank, the hedge fund assumes the risk associated with that loan and gives the bank its capital back. Subsequently, banks are able to loan out that new capital.
More VS Investments
The existence of hedge funds helps VCs (venture capitals) to invest in start-ups. Whenever a VC considers investing in a start-up, their primary concern is their exit. They want to know how they are going to make their money back. For a VC, there are two main ways of making money: dividends and being bought out. A hedge fund with a lot of liquidity greatly increases the chance of being bought out of a start-up, especially if the start-up proves to be lucrative.
You Make Plans for the Future
Hedge funds invest in future contracts. Consequently, they shoulder the risk a lot of small businesses experience. A futures contract is an agreement to buy a particular product at a pre-set price at a given date, regardless of the actual price of that product at that date. This offers some stability and peace of mind for the producers of said product.
Undoubtedly, the topic of hedge funds warrants much more discussion. Nevertheless, for our purposes, this will do. We’ve covered what is a hedge fund, as well as how it can aid start-ups. We’ve seen how the management of a great deal of wealth can influence the economic ecosystem. If you can think of another way that hedge funds affect start-ups, leave a comment below and let us know.
Images taken from depositphotos.com.