Do Hedge Funds Invest in Startups? The How & Why

Hedge funds, traditionally known for their strategies in public, liquid markets, are increasingly expanding their reach into the private startup ecosystem. These investment vehicles pool capital from high-net-worth individuals and institutional investors, employing diverse strategies to generate returns. The common perception often confines their activities to stocks, bonds, and derivatives, but this view is evolving as market dynamics shift.

The Landscape of Hedge Fund Startup Investments

Hedge funds have established a growing presence within the startup investment landscape. Reports indicate that between 61% and 70% of hedge funds now engage in private equity investments. This increased involvement stems from a broader trend where companies are opting to remain private for longer periods.

The median age at which a company goes public, for instance, rose from 6.9 years in 2014 to 10.7 years in 2024. Private markets have matured significantly, offering businesses viable avenues for capital raising and liquidity that were once primarily exclusive to public listings. This extended private phase means that considerable value creation occurs before a company reaches the public market, prompting hedge funds to seek opportunities earlier in a company’s lifecycle.

The types of hedge funds participating in startup investments vary, but dedicated “crossover funds” are notable. These funds are designed to invest in both publicly traded and privately held companies, bridging the gap between the two markets. Other large multi-strategy funds also actively deploy capital into private ventures.

Hedge funds typically target later-stage growth rounds and pre-IPO investments, often focusing on companies seeking Series C funding or beyond. These investments can range from $10 million to $500 million, reflecting their capacity for substantial capital deployment. Their primary interest lies in more mature startups with established traction and clearer paths to future liquidity events.

Hedge Fund Investment Approaches in Startups

Hedge funds use various mechanisms and strategies when investing in startups. They frequently utilize preferred equity, a financial instrument that grants investors priority over common stockholders in receiving dividends and proceeds during liquidation events. This structure provides a blend of security and flexibility, positioning preferred equity between traditional debt and common equity in a company’s capital structure. Such arrangements often include specific liquidation preferences, ensuring investors recover their capital before common shareholders in the event of a company sale or dissolution.

Convertible debt, often in the form of convertible notes, is another instrument, particularly in earlier funding stages. These notes begin as loans to the startup, designed to convert into equity at a later date, typically coinciding with a subsequent qualified financing round. This approach allows startups to defer a definitive valuation until more traction is established, while investors receive a discount on the future share price, commonly around 20%, as compensation for their early risk.

Beyond direct equity and convertible instruments, hedge funds also engage in secondary market purchases. This involves acquiring existing interests in private equity funds or direct stakes in privately held companies from other investors. The secondary market provides liquidity for selling investors and offers buying hedge funds an opportunity to gain exposure to mature, established portfolios, sometimes at a discounted valuation.

The due diligence process undertaken by hedge funds often differs from that of traditional venture capital firms. Hedge funds are more financially driven, emphasizing a startup’s financial metrics and unit economics. They scrutinize key indicators such as burn rate, revenue growth, profit margins, customer acquisition cost (CAC), customer lifetime value (LTV), and monthly recurring revenue (MRR) growth to assess financial stability and scalability.

Unlike many venture capitalists who may seek significant operational involvement or board seats, hedge funds tend to be less hands-on in the day-to-day management of their portfolio companies. They are often willing to invest at higher valuations and can streamline the due diligence process, providing capital quickly. This focus allows them to concentrate squarely on the investment opportunity and its potential for financial returns.

While their investments span various industries, technology and life sciences sectors frequently attract substantial hedge fund capital due to their growth potential.

Drivers Behind Hedge Fund Engagement

Hedge funds are increasingly drawn to startup investments due to a strategic pursuit of higher returns and portfolio diversification. In an environment where traditional public market strategies face increased competition and potentially lower yields, private markets offer an avenue for enhanced performance. Historically, private equity and venture capital strategies have demonstrated superior annualized returns compared to public equities over long periods, making them attractive for capital appreciation.

This strategic shift also reflects a desire for diversification beyond conventional asset classes. Private market investments often exhibit a low correlation with public stocks and bonds, which can contribute to a more resilient and balanced investment portfolio. By adding private assets, hedge funds can reduce overall portfolio volatility, creating a more stable return profile even amidst fluctuating public market conditions.

The evolving investment landscape has also contributed to the blurring lines between public and private equity. Hedge funds are expanding into areas traditionally dominated by private equity firms, such as direct investments in private companies. This convergence reflects a broader market trend where the distinct boundaries between these asset classes are becoming less defined, prompting investors to seek opportunities across the entire corporate lifecycle.

Furthermore, the concept of an illiquidity premium plays a role in attracting hedge funds to private startup investments. This premium represents an additional return investors expect to receive for committing capital to assets that are not easily convertible to cash. Private equity demands a long-term commitment, and the illiquidity premium, which can range from 2% to 6% annually, compensates investors for this reduced flexibility and longer holding period.