Could you elaborate? My first inclination is to strongly disagree having worked on hedges before, but if you know something I do not I'd like to hear about it.
Edit: You can create hedges on unknown time-horizons with unknown returns but rather quickly the cost of maintaining the hedges should drastically outpace their value as hedges. Time volatility on the order of years is harder (read much more expensive) to deal with than revenue volatility with a known time-horizon.
So, while you can create a theoretical hedge instrument, the application of such an instrument is untenable as a profitable hedge in practice. (from my personal experience, would still love to be proven wrong here)
You seem to have more experience hedging in the real world than me but I'll bite anyway...
"So, while you can create a theoretical hedge instrument, the application of such an instrument is untenable as a profitable hedge in practice"
There is an infinite amount of hedges that can be created with synthetic financial instruments. Some instruments haven't been invented yet and even if they have been invented you have to convince somebody else to take the other side of any trade. Credit default swaps, options and just about any other instrument were new, unproven and potentially secret at some point. Right now there could be somebody who has figured out a way to do some kind of time horizon hedging and is going to make bank when some startups do/don't IPO.
I actually think it's quite likely.
Edit: Having read some of your other comments on here I would rephrase my answer as this: why would a time-horizon hedging strategy be any less successful than any other hedging strategy?
The framework I'm operating from includes the time-value component of the fund. If a fund has a target rate of return of 10% per annum, each additional year they wait for a liquidity event requires an additional 11% (1 / 0.9) in returns in order to hit their target.
So a valuation drop of 20% is comparable to ~2 years delay in liquidity. My strong suspicion is that the price volatility is small relative to the time volatility in these startups. There's a lot more knowledge around addressing the pricing volatility issues than the liquidity issues (an unexpected liquidity issue in the short-term markets is what caused both Bear Sterns and Lehman Bros to fail). In the end I believe that delayed liquidity events, in the market we are entering, are going to be strongly correlated with reduced IPO value.
To directly answer you question : the challenges of hedging for the time horizon of liquidity events will also include price volatility issues as well. So essentially if you're worrying about liquidity you still have to worry about price, where in saner times there are vehicles where you only have to worry about price. More hedges means more carry cost and less-profits. So what I meant by the "untenable" is that I don't expect the cost-value to be there in those circumstances.
Definitely possible that I'm wrong here, I just think the odds are against anyone dealing with those types of problems.
I have zero experience in this area, but regarding the price volatility, I was under the impression that a lot of the massive late-stage investment rounds had been structured more like debt. So something like 2-3x liquidity preference, with a cap on returns[1]. Not sure if this is what the hedge funds are doing, but if so, seems like they are controlling the price and taking a risk on the time horizon. Of course the fact that they are heading towards the exits (according to this article) implies it's not going as expected.
Would you mind giving an ELI5 explanation of how hedge funds currently handle exit value volatility (minus the unknown time-horizons aspect) for those of us who haven't worked on hedges before?
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.
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.
"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.
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.
I very much doubt that they do it in the exact methodology I described but I assure you that market participants do this.
There is probably published material available on 70's and 80's hedging techniques but now that they are known the market converges. The problem with what you're asking now is that anyone privy to modern strategies would be sued out of existence for divulging them. A successful hedging strategy is very much classified as a trade secret.
The only thing of value a hedge fund provides, if it does indeed provide any value, is it's investment strategy. There are no perfect hedges because they'll typically be arbitraged out of existence but the logic that goes into hedging is the reason liquidity preferences exist now.
The finance industry has a wholly different outlook on things than normal people so I understand the confusion here, it took me a bit to fully grasp why and how to do things even once I was immersed in the industry.
Also, I should emphasize here: the theory behind the concept looks pretty but in application the assumptions can completely obliterate the success of the investment. The book "A Random Walk Down Wall Street" by Burton Malkiel covers a lot of the finance industry from an academically rational perspective.
If you read that book you'll take away the counter point to everything I've said here. Which is, there is no evidence in advance that a hedge fund can successfully hedge. After the fact, survivor bias may mislead us into believing that what appeared to be a sound strategy may have just been luck.
At the end, the challenges to hedging aren't obtaining the appropriate instruments or taking on the risk, these are problems that all major financial entities are comfortable dealing with. The challenge in hedging is that you don't know how accurate your assumptions are until the hedge is complete.
Essentially when crafting a hedge you are playing a binary scenario (A wins and B fails, or A fails and B wins). The problem is that the input assumptions also need to hedged, and then you have assumptions on those hedges, and so on.
Thanks for all of your insights here, this was very interesting to digest.
I just started reading "A Random Walk Down Wall Street" and it is solid so far. How good of an investing primer would you say it is for a novice? Are there other good books you'd recommend?
Also, I do modeling for advertising as part of my day job, but I've always been curious how much of that analysis/optimization skillset is applicable to trading and risk modeling. Are there any good introductory primers you'd recommend?
Lastly, in The Big Short movie, how accurate is the scene where they first have discussions with Goldman about the bespoke instrument? It looks like the quant sits there listening, the two Goldman folks whisper a bit, and then they say they'll do it under XYZ terms. I'm guessing in real life they'd meet, Goldman would go back and model stuff on their end to determine the terms, then come back with what they'd be willing to do and it wouldn't happen in the span of a conversation like that. Can you shed any light?
For finding good resources on personal investing (these sites will have the standard suggested reading):
www.reddit.com/r/personalfinance
www.bogleheads.com
If you want to apply your abilities to investing it's a little harder. The theme of Malkiel's book is that there is no way to regularly beat the market, and I agree with him. There are opportunities but they require a great deal of effort, resources, and risk tolerance. Look into George Soros shorting the pound (I think that's the story), what I typically do now is follow along with what the big boys are doing publicly, evaluate it on my own, and then make an investment there. I avoid leveraging, futures, or going short because I will never be able to devote as much time to valuing them as other market participants. I have recently purchased a fair amount of Alcoa based on some "activist investor" market theses.
What you want to do is learn the basics (how to invest personal money in the standard fashion, based on Malkiel and Bogle). Then come up with a riskier strategy on top of that that either leverages someone elses analytical hard work or requires minimal effort on your part. There are hundred of people you'd be competing with working hundred hour weeks if you were to try to play the leveraged game (doesn't mean you can't win thought).
I never worked with Goldman or their ilk so I can't speak from personal experience. My guess would be that there was no personal meeting, just an email exchange followed by some quant analysis, followed by negotiation (in person, over phone, or over chat). You're definitely right that that scene was a hollywood fiction.
If you want to chat more feel free to email me at iawHackerNews at gmail dot com.
Easy -- for an "imperfect hedge", find a comparable company and sell an opposite instrument. If you are holding illiquid stock in VenMo for example, buy puts on either a the NASDAQ or PAYPAL. As the value of one goes up, the value of the other generally goes down, you are generally even.
For a "perfect hedge", find a counterparty willing to bet on the price of what you own (perhaps they have an opposite exposure) and have them take the opposite side of a forward or swap for your illiquid stock.
Good explanation, but maybe use Dwolla instead of Venmo (Paypal bought Braintree a few years ago, which had bought Venmo prior to that -- So Venmo is now a subsidiary of Paypal).
