Hedge Funds Raise the Pirate Flag
By Eric Hellweg

(Business 2.0) – Back in the days of the tech bubble, the enormous checks that venture capital firms sent to their investors canceled out the enormous uncertainty that went along with backing brand-new companies. Not anymore. Swashbuckling hedge fund managers are now shaking up the world of institutional investing, while venture capitalists are taking the safe route, looking for more predictable (if smaller) returns.

Why are VCs becoming cautious while hedge funds play offense? Many VCs worry about returning profits to their limited partners and are no longer able to mine a white-hot IPO market. Rather than laying risky wagers on unproven startups, they're placing safer bets on growing mid- and late-stage companies. Meanwhile, hedge fund managers have discovered that by hunting in packs--buying up shares in one company, shaking up the boardroom, raising the share price, and exiting fast--they can create double-digit returns not seen since the go-go years of limited buyouts during the 1980s.

The venture capital game has certainly become less exciting since the IPO market cooled off. A typical VC exit strategy now involves selling a promising startup to a larger company--a Cisco or an IBM--for a return of as much as four times the investment. That's a far cry from the eye-popping 10-fold returns the tech bubble offered. "You don't make a grand slam on most acquisitions," says Mark Heesen, president of the National Venture Capital Association, "but at least there's one avenue open for us."

Hedge fund managers may seem more secure, but they can hardly relax. VC funds take at least seven years to unravel; hedge funds can implode in a matter of months. The drive to stay on top has forced them into strategies they might never have considered--hence the resemblance to corporate raiders of the 1980s. Appropriately, the movement even has a familiar poster child--Carl Icahn, one of the most infamous aggressive investors of the 1980s, has been at the helm of hedge-fund-led corporate takeovers of Blockbuster and Kerr-McGee, and he's now attempting to shake up Time Warner (parent company of this magazine).

But with average returns dropping to 3.6 percent in 2005, the hedge fund industry may have passed its high-water mark. The place to look for returns several years down the road is exactly where everyone isn't--in this case, early-stage venture capital. Early-stage valuations are still reasonable compared with those of mid- and late-stage companies. A minor piece of a well-capitalized company like Vonage might cost $20 million, but you can get 40 percent of a promising early-stage software company for $2 million. Just remember: No gold rush lasts for long. While the smart money may congratulate itself in 2008 for its farsighted bets on early-stage VC funds, the really smart money will already be on to the next big thing. -- ERIC HELLWEG