What's the Difference Between a Hedge Fund and a Venture Capital Fund?

By Markets Fool.com

Both hedge funds and venture capital funds offer investors opportunities to make money. They share the same ultimate goal of generating the highest possible return through smart investments, but they have some fundamental differences that investors should understand.

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Hedge funds
Hedge funds are private investment funds that pool capital from investors and use specific strategies to generate a return on investment. The name is derived from the practice of hedging market risk by pairing complementary investments and thereby offsetting losses. Hedge funds are typically classified according to their investment style. While some hedge funds focus on stocks, for example, others focus on distressed debt or commodities.

Hedge funds are managed by professionals who develop and execute their respective investment strategies. Those who manage hedge funds often invest their own money as well. This helps to align their interests with those of shareholders, which can lead to higher investor confidence. Hedge fund managers generally receive an annual management fee, which is a percentage of assets under management, as well as a performance fee, which is a percentage of the increase in the fund's net asset value over the course of each year.

Venture capital funds
Also known as VC funds, venture capital funds are funds that manage money from investors looking for private equity stakes in growing companies. Generally, venture capital funds invest in start-ups and small companies with significant potential for growth. In fact, many start-up companies rely on venture capital funds to get off the ground, as most aren't large enough to raise capital by issuing stock to the public or aren't established enough to secure traditional bank financing at favorable rates. Typically, when a venture capital fund agrees to finance a small operation in its early stages, it will provide an initial round of funding to fuel growth with the intent of generating a sizable return through an eventual exit strategy, such as when the company files an IPO (initial public offering) or is sold to a larger company. Because investing in start-up companies constitutes a significant risk, in exchange for their funding, venture capital funds generally demand a significant ownership stake and some degree of control over business decisions and strategies.

Making money is the end goal
Both hedge funds and venture capital funds seek to make money on their investments, and both take on risk in order to do so. The key difference between the two is that while hedge funds have the ability to make money when investments grow or decline in value (because they can short investments in order to hedge their long calls), venture capital funds need the companies they invest in to be profitable in order to make money themselves. Venture capital funds also tend to take a more hands-on approach to their investments, while hedge funds are often unable to directly influence the performance of the companies in which they invest.

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