At a glance
- Record fundraising from traditional investors gave U.S. venture capital funds the dry powder needed to fuel explosive growth in 2021.
- A growing list of nontraditional VC investors allowed startups to raise even more capital and resulted in the emergence of hybrid funds.
- Hybrid funds merge the open-end features of the hedge fund structure with the closed-end features of private equity and VC funds to create a more fluid structure that offers investors key benefits.
U.S. venture capital deal activity reached $330 billion in 2021, nearly doubling the previous record of $167 billion in 2020, data from PitchBook shows.
Record fundraising from traditional investors gave VC funds the dry powder needed to fuel this explosive growth, but that wasn’t the only factor at play; a growing list of nontraditional VC investors allowed startups to raise even more capital and resulted in the emergence of hybrid funds.
Stellar returns and realized gains captured by VC funds—thanks to the expansion of valuations and a hot initial public offering market—have pulled hybrid funds into the stream of nontraditional investors that have increased their participation in the VC space.
Hybrid funds merge the open-end features of the hedge fund structure with the closed-end features of private equity and VC funds to create a more fluid structure that offers some liquidity under certain scenarios and locks in capital to match the investment horizon for less liquid investments.
An increasing number of hedge fund and private equity fund managers are including hybrid funds as part of their offering to invest in startups, hoping to capture returns earlier in the life cycle of portfolio companies. This trend is expected to continue as investor interest in VC persists.
We expect more midsize managers to pursue strategies using the hybrid fund structure, which has historically been reserved for late-stage companies.
As VC dry powder has become more plentiful, allowing startup companies to tap into this capital source more easily, companies have stayed private longer, with the goal of listing via IPO when they are much more mature. Nontraditional VC investors have recognized the need to get in the game earlier, before a significant portion of the value has been created and captured, as showcased by some mega IPO VC exits in recent years.
For hedge funds, the delay in IPOs of private companies limits the pool of newly listed companies on the stock market with significant room to grow. For private equity funds, VC investments can be complementary to buyout or growth equity strategies.
Even traditional VC funds are seeing the benefit of a hybrid structure. Sequoia Capital, the venerable VC firm that has funded some of the biggest breakout startup companies over the past few decades, announced in October 2021 that it was revamping its structure to move away from the traditional closed-end fund. Recognizing that the traditional 10-year term no longer offers the flexibility to back some startup businesses that may require a lengthier investment horizon to unlock the most value, Sequoia moved to a continuously offered fund that will invest in an underlying portfolio of liquid companies and closed-end fund structures.
Sequoia’s restructuring highlights how hybrid funds can come in different shapes and formats, allowing fund managers to customize them to the needs of their investment mandate and investor base. For example, some funds will offer all investors a combination of liquid and illiquid subclasses with varying liquidity terms. In contrast, others may make continuous offerings of a series of subfunds in which investors participate at their discretion. Fee structures vary from fund to fund, with some hybrids having a limited life while others continue indefinitely.
The custom structures of hybrid funds come with their own unique set of challenges. Operational complexity can be elevated significantly as managers seek the best way to treat investors fairly while allowing ways to raise capital continuously. The calculation of fees, valuation of illiquid investments, allocation of deals among subpools, and determination of when investors can redeem are a few operational issues that can be complicated by the hybrid fund structure.
Large, reputable fund managers, such as Tiger Global Management, Coatue and D1 Capital Partners, have straddled the middle ground of investing in both private and public markets for several years. We expect more midsize managers to pursue similar strategies using the hybrid fund structure, which has historically been reserved for late-stage companies. As this fund structure gains popularity, investment targets may also evolve to include more early-stage deals.
As interest in VC continues to grow, more flexible structures will emerge to cater to the needs of investors and blur the lines between open-end and closed-end structures. Hybrid funds appear set to continue emerging in different formats and become a bigger driving force for VC activity.