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Lets assume no fundamental issues with the economy, e.g. we're only worried about companies competing with eachother not a financial crisis. The expectation of

by iaw 11y ago

Lets assume no fundamental issues with the economy, e.g. we're only worried about companies competing with eachother not a financial crisis. The expectation of a startup is typically that it will disrupt an existing industry or fail to do so. If it disrupts an existing industry, existing market participants will lose marketshare. Knowing who the competitors are in a given space, and how they contribute to the overall market, allows the hedge fund to model what the long-term revenue streams of a startup could look like. More importantly, they model how much money competitors and contributors to the space will make or lose due to the market change. Having these expectations they can then acquire futures contracts (contracts that allow them to fix the price and date they pay or receive for a publicly traded security) opportunistically during normal market fluctuations. If the hedge is working perfectly they will make money back regardless of whether the company succeeds or fails. Trains vs. Buses vs. Cars with inputs of fuel is a classic hedge model example (although rather simplistic). Lately hedge funds (and other early investors) are building their hedges into the investment itself with liquidity preferences which are creating their own sets of problems. Basically, liquidity preferences can be thought of as a hedge on their investment but they lose a lot of hedge value when they don't know when the liquidity event will occur. Sorry if that isn't ELI5 enough, hedges are a pretty complex animal and it's hard not to jump down every rabbit hole detail.

wmfiv 11y ago
In a completely theoretical way what you say is possible. But in practice does anyone actually do this? What's the time frame you'd be willing to stake your career on for a startup (event a fairly mature one) to be meaningfully impacting the overall profitability of it's astronomically larger competitors? And you'd be simultaneously betting against overall bull markets and that the incumbents won't adapt, whether in the market directly against the startup or in any of the other markets they're in. To my knowledge you can't even trade in stock futures with sufficiently distant expiration dates to do this.
- iaw 11y ago
  "To my knowledge you can't even trade in stock futures with sufficiently distant expiration dates to do this." To put this as politely as possible, you are incorrect. When you have more than $1 billion under management there are numerous counter parties more than willing to design bespoke financial instruments to suit your needs. My first role in finance involved modeling the risk associated with the bespoke instruments that people were asking my tiny (<$1 billion) firm to create. If you watch 'The Big Short' 1/3rd of the movie is devoted the creation, acquisition, and distribution of a bespoke financial instrument traded upon layers of bespoke instruments (Credit Default Swaps, Credit Default Obligitions, rolled bond instruments, etc.) Remember when Christian Bale's character gets chewed out for losing so much money a month? It's because he's paying to maintain his bespoke put options on mortgage backed securities. "What's the time frame you'd be willing to stake your career on for a startup" I left the industry, I find it pretty disgusting to be quite honest. However you're missing the fact that these hedge funds don't invest in one startup, they invest in dozens in an effort to diversify their risk. Furthermore, if you think a fund manager is "staking their career" by making these bets you missed two important facts: * 2 and 20, they're taking home 2% under management even if they lose it all. * By the time someone is in the position to manage that many investments they are both able to retire and sell themselves into any position. There's as many, if not more, investment managers that lose money as make it. Their job is to quantify and tolerate risk, quite often that entails losing money on some investments. Anecdotally, when I first started in the industry we had a director who lost $30MM in the course of 2 weeks on an investment. We had hit a risk case that exceeded the 99th percentile on an investment strategy he had developed. A month later we had recouped the $30MM with an additional $60MM of profit. He took an educated risk and it could have made us take a loss for the year. Importantly, all of our other investments performed wholly within expectations during that time frame. So, while we were losing money hand over fist during those weeks it was never an existential risk to the company.
  - wmfiv 11y ago
    Fair enough about the bespoke products. But does anyone really do this? Are there published examples of people doing this or talking about doing it? I can find plenty of examples of hedge funds betting on single mid or late stage startups but not doing what you're suggesting here. What you're suggesting is incredibly interesting so I don't intend to be rude but the concept strikes me as ludicrous. The assumptions that would go into a financial model for something like this seem ridiculous to me. You'd be betting/guessing/hedging on countless company, industry and macro-economic variables over a long, long time frame.

by iaw 11y ago

wmfiv 11y ago

In a completely theoretical way what you say is possible. But in practice does anyone actually do this? What's the time frame you'd be willing to stake your career on for a startup (event a fairly mature one) to be meaningfully impacting the overall profitability of it's astronomically larger competitors? And you'd be simultaneously betting against overall bull markets and that the incumbents won't adapt, whether in the market directly against the startup or in any of the other markets they're in. To my knowledge you can't even trade in stock futures with sufficiently distant expiration dates to do this.

iaw 11y ago
"To my knowledge you can't even trade in stock futures with sufficiently distant expiration dates to do this." To put this as politely as possible, you are incorrect. When you have more than $1 billion under management there are numerous counter parties more than willing to design bespoke financial instruments to suit your needs. My first role in finance involved modeling the risk associated with the bespoke instruments that people were asking my tiny (<$1 billion) firm to create. If you watch 'The Big Short' 1/3rd of the movie is devoted the creation, acquisition, and distribution of a bespoke financial instrument traded upon layers of bespoke instruments (Credit Default Swaps, Credit Default Obligitions, rolled bond instruments, etc.) Remember when Christian Bale's character gets chewed out for losing so much money a month? It's because he's paying to maintain his bespoke put options on mortgage backed securities. "What's the time frame you'd be willing to stake your career on for a startup" I left the industry, I find it pretty disgusting to be quite honest. However you're missing the fact that these hedge funds don't invest in one startup, they invest in dozens in an effort to diversify their risk. Furthermore, if you think a fund manager is "staking their career" by making these bets you missed two important facts: * 2 and 20, they're taking home 2% under management even if they lose it all. * By the time someone is in the position to manage that many investments they are both able to retire and sell themselves into any position. There's as many, if not more, investment managers that lose money as make it. Their job is to quantify and tolerate risk, quite often that entails losing money on some investments. Anecdotally, when I first started in the industry we had a director who lost $30MM in the course of 2 weeks on an investment. We had hit a risk case that exceeded the 99th percentile on an investment strategy he had developed. A month later we had recouped the $30MM with an additional $60MM of profit. He took an educated risk and it could have made us take a loss for the year. Importantly, all of our other investments performed wholly within expectations during that time frame. So, while we were losing money hand over fist during those weeks it was never an existential risk to the company.
- wmfiv 11y ago
  Fair enough about the bespoke products. But does anyone really do this? Are there published examples of people doing this or talking about doing it? I can find plenty of examples of hedge funds betting on single mid or late stage startups but not doing what you're suggesting here. What you're suggesting is incredibly interesting so I don't intend to be rude but the concept strikes me as ludicrous. The assumptions that would go into a financial model for something like this seem ridiculous to me. You'd be betting/guessing/hedging on countless company, industry and macro-economic variables over a long, long time frame.