Venture hedge funds?

Here's an interesting idea from Bill Hilliard and Charles Baden-Fuller for venture capital funds to increase their performance: invest in start-ups and buy put options on their competitors' stock shortly before the start-up publicizes market-entry, an IPO etc. Or in plain English: invest in company X, then use your inside information on company X to place bets on its competitors' stock prices. If X announces a success, you can expect its competitors' stocks to fall in the short-run.

It sounds like insider trading but isn't because the VCs don't have any inside information on the companies they're betting against. The information is private, but apparently there's no law against using it.

As with hedge funds, it's easy to forget that these increased revenues come with increased risk. However, private information is a clear advantage, and VCs get to diversify risk across time between short-term bets and long-term investments.

Any estimates of extra returns from using hedging strategies “must factor in risks and transaction costs,” [Baden-Fuller] says. “Stock prices of companies can move up when market experts expect them to move down. There are carrying costs to put options.”

But Hilliard and Baden-Fuller write that possession of “asymmetric information shades the risk in favor of the venture investor analogously to the way that card counting adjusts the odds in blackjack.” They also maintain that acquiring put options in transparent markets may be inherently less risky than any underlying venture investments made by the venture fund in the potentially disruptive new company itself.

If the model works (and remains legal), there will be cases where the options trade will allow projects to be financed that could not be financed otherwise, except perhaps by government subsidy.