How hedge funds are disrupting venture capital?
Startup investing has been the domain of Venture Capitalists (VCs) for years. VCs understand the risks that come with startup investing. But Hedge funds and Private Equity funds are now outsmarting VCs in their game. We don't know how this will end.
Successful investments require specific skills. And in most cases, these skills at not transferable. Warren Buffett calls this the circle of competence.
Mr Buffett is known for not investing in technology businesses because he says he doesn't understand them. All successful investors are like Mr Buffett. They stick to what they know. Real estate guys stay away from public equities, equity managers don't invest in debt, and debt investors keep cryptos and other speculative assets at bay.
Venture capitalists (VCs) are no different. VCs invest in startups because they understand these companies best. They don't do private equity or currency or structured products. Few big VCs have dominated venture capital for years. Most of these funds were started by successful founders who became investors after selling their companies. They understood technology and startups because they had been there and done that.
But the industry is undergoing an upheaval. The global inflow of venture capital has exploded. Funds invested $288 BN in startups (under different stages) in the first 6 months of 2021. This was a 61% increase in the last 6 months of 2020, which anyways was an all-time high.
So where is all this money coming from?
1. Traditional VCs are getting bigger. Fund managers are raising bigger funds because the investor interest in startups is increasing. Startups are no longer niche or speculative assets that require specialised knowledge.
2. But that's not the full story. Startups are attracting new investors. Big private equity and hedge funds are investing in late-stage startups because they have seen VCs make huge returns over the years.
Thus, traditional VCs no longer dominate the venture capital industry. Outsiders are taking over. Out of the 10 most prolific venture capital investors in H1 2021, 4 were non-traditional VCs. That's a big disruption for an industry known for backing disruptions in other industries.
One way to look at this new development is more and more people/funds understand startup investments than before. This is a heartening sign for founders and startups. They have achieved mainstream acceptance.
The other view is all these investors are doing something they don't understand. There is more money in the world than ever. Thus, the big funds are becoming speculative and venturing out of their circle of competence. The data supports this hypothesis. Hedge funds and PEs are investing much more in startups than traditional VCs.
And if the second hypothesis is correct, we all know how this venture capital good rush will end. We have seen economic bubbles come and go. Let's hope this one doesn't leave a trail of destruction in its wake. That would be a tragedy. And Mr Buffet won't approve this.