Playing With Wire » Andreas Lindblom The Internet Startup Blog Wed, 20 Jul 2011 18:45:29 +0000 en-US hourly 1 Using Hedge Funds for Start-ups Fri, 24 Nov 2006 15:02:00 +0000 Before getting down to business I would like to introduce myself. My name is Andreas Lindblom and I’m invited as a guest writer to share with you the interesting world of Hedge Funds and how their presence might be applied to start-ups.

Starting off, defining Hedge Funds might be a good idea as many still don’t really know what constitutes a Hedge Fund.
Hedge Funds “are not regulated by the SEC, meaning that they are not required to disclose all financial statements and are allowed to engage in selling short” (Lindblom, pg. 1). This is, of course, an oversimplified statement that would cause many Hedge Fund experts so shiver, but for this article, Hedge Funds are like Mutual Funds, apart from the mentioned fact that they are not regulated by the SEC and that they can be involved in selling short. These differences are immense as they cause potential gains to sky rocket. With this, the volatility of the investment also rises, thus potential losses could be devastating for a start-up. There are additional criteria related to Hedge Funds, but those will be discussed later on.

When researching risk-adjusted returns, one should use use several models so that all factors are accounted for and also focus on models that use multiple factors to calculate returns. Such factors could be ‘Fama and French’ or Carhart’s four-factor model, compared to CAPM which assumes perfect market efficiency and also restricts you with certain limitations.

Using these models to analyze risk-adjusted return, my research found that Hedge Funds outperform the market almost exclusively (as seen on the efficient frontier below) which implies that the choice of investing in Hedge Funds should be an easy choice? Well, here’s comes the additional criterion to investing in Hedge Funds. “In order to invest in a Hedge Fund [the investor needs] $5 million in capital to invest, and…a sophisticated understanding of the financial markets. [Hedge Funds] also accept funds from institutions such as pension funds that have at least $25 million in capital available” (Lindblom, pg. 5). ‘The cream of the crop’ may claim that this is good because it creates an exclusive investment market or a ‘playground’ rather where they are not restricted by the SEC. Given that Hedge Funds can sell short, many of them are levered, thus potential losses could shake the financial waters of the US significantly and affect other, rather than just those investing in that particular fund. Due to this, many ‘regular’ investors and analysts oppose Hedge Funds because as seen at the end of the 1990’s where the LTCM (Long-term Capital Management) Fund crashed, requiring all major Investment Banks to bail them out.

Well, maybe it’s time to start applying what we know to start-ups. Management of a start-up could have many difference mentalities. Maybe they are risk aversive or risk-takers. The size of capital available to invest may differ, and so on.
Investing in Hedge Funds could provide a company with major returns but, of course, also higher volatility. The size of a start-up is significant due to the $5 mn. investment requirement. For a start-up, where the first year determines the future of the entire business, investing in Hedge Funds provides volatility you’d much rather avoid and investing in Mutual Funds or simple CDs may be a better choice due to its lower volatility (note: investing in CDs requires you to ‘lock’ your funds which decreases the liquidity of your funds significantly).
Personally, I would invest extra capital in R&D for a start-up due to the importance of keeping your customer base after, if surviving, the first year.

For further information, read my research on “Risk-adjusted return of Hedge Funds.”

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