One venture capitalist is beating the hedge fund managers at their own game

During the past few years, a number of major hedge-fund investors have put money into young, private companies to test their chops as venture capitalists. But in a rarer move, at least one prominent venture capitalist, Chamath Palihapitiya, is going the other way.

Earlier this year Palihapitiya, who runs the $1.5 billion venture firm Social Capital, launched a small internal hedge fund for third-party investors.

The idea behind the fund, a precursor to which was opened in 2013 using Palihapitiya's own capital and that of some colleagues, was to harness the research process his firm has honed for identifying future success stories in the private arena, and direct it toward smart public-market investments.

"The premise was really simple, which is that what is the real difference between a private company and a public company, and to be honest with you, there is very little difference — except the scale in which it is at in terms of long-dated ultimate value," said Palihapitiya in an interview at the Sohn San Francisco investment conference on Oct. 5. "And so we kind of treat everything as a company. We never talk about ticker symbols. We never talk about buying and selling. We talk about investing and owning, and so far so good."

On May 1, Palihapitiya's firm opened Social Capital Public Equity Partners. Since then, it has posted more than 6 percent returns net of fees, noted Palihapitiya, beating both the stock market and the average hedge fund. That performance has been driven in part by Amazon (AMZN) — a stock the fund managers believe will be worth $3 trillion within 10 years — which has risen about 27 percent since the beginning of May. Other long positions include Workday (WDAY), the finance and human resources cloud company whose growth potential Palihapitiya touted at the recent Sohn conference, and the cloud company NetSuite (NYSE:N), which is set to be acquired by the software giant Oracle.

Palihapitiya is one of many company investors who place their bets in multiple ways. He appears, however, to be one of the few who has begun in venture capitalism and then branched into hedge-fund management.

Usually, it's the other way around. In recent years, Steve Cohen, Philippe Laffont, John Burbank and Lee Ainslie, all of whom are best known for running hedge funds, have done the reverse. Rivals like Dan Loeb, who first opened a venture fund in 2000 and has invested in companies like the Chinese ride-sharing service Didi and the big-data company Palantir, and Chase Coleman, who has raised 10 venture capital funds since 2003 and helped fund the likes of Facebook (FB) and LinkedIn (LNKD), have been doing so for longer.

In some ways, the synergies between the two investment styles are obvious: Fresh investment opportunities flow naturally toward deep-pocketed money managers with good contacts in the corporate world, and hedge fund managers typically employ analytical research that's helpful in understanding investment targets. But the volume, duration, and scale of public-market investing, where hedge-fund managers often trade rapidly in and out of a relatively large portfolio of stocks and other assets, is quite different from the longer-term, often more analytical world of venture capitalism.

"The people who are concentrated in, A, things they're expert on and, B, a relatively small number of them where they can wrap their arms around them … are going to tend to do better in picking stocks," said Randolph Cohen, a senior lecturer at the Harvard Business School whose studies have shown that it's the high-conviction ideas in a typical mutual fund investor's portfolio that outperform the rest of the basket.

"But what I want to be clear about is, it's not that I think being a venture capitalist or a private equity person magically makes you better," Cohen added. "It's that being focused or being concentrated is better. And normally hedge fund managers don't invest that way," the exception being activists with smaller, often better-researched, portfolios.

Matthew Granade, who oversees an internal venture capital fund at Point72, former hedge-fund manager Steve Cohen's $11 billion family office, says the differences in thinking between most venture capitalists and an investor like his boss are often apparent.

"VCs think a lot about what I would call sort of intangible things, like team, and product-market click, and it's a little bit like, you call it when you see it," he said. "Steve is a public-markets investor, so when you bring it to him, he says, 'How much revenue are they doing, how fast is it growing, what's the valuation, what's the revenue multiple.' Then he'll sort of say, 'OK, then take me out a couple of years; what's the gross margin going to be, what's the EBITDA going to be?' He thinks of them already as more grown up companies."

Palihapitiya said that one key for him in any investment, and certainly in his internal hedge fund, is creating a "logical model" for the future of a company. Although the fund is mostly oriented toward value, or long-term, ownership of stocks, he added that there are two short, or bearish, positions in the basket right now betting on companies whose models "aren't as enduring and will not stand the test of time." He declined to name them.

Correction: An earlier version misstated the origins of the Social Capital Public Equity Partners fund. Palihapitiya was interviewed at the Sohn San Francisco investment conference on Oct. 5. An earlier version misstated the day.

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