Hedge Fund vs. Private Equity Fund: An Overview
Both hedge funds and private equity funds appeal to high-net-worth individuals (many require minimum investments of $250,000 or more), traditionally are structured as limited partnerships, and involve paying the managing partners basic management fees plus a percentage of profits.
- Hedge funds and private equity funds appeal primarily to individuals with a high net worth.
- Both types of funds involve paying managing partners basic fees as well as a percentage of the profits.
- Hedge funds are alternative investments that use pooled money and a variety of tactics to earn returns for their investors.
- Private equity funds invest directly in companies, by either purchasing private firms or buying a controlling interest in publicly traded companies.
Hedge funds are alternative investments that use pooled funds and employ a variety of strategies to earn returns for their investors. The aim of a hedge fund is to provide the highest investment returns possible as quickly as possible. To achieve this goal, hedge fund investments are primarily in highly liquid assets, enabling the fund to take profits quickly on one investment and then shift funds into another investment that is more immediately promising. Hedge funds tend to use leverage, or borrowed money, to increase their returns. But such strategies are risky—highly leveraged firms were hit hard during the 2008 financial crisis.
Hedge funds invest in virtually anything and everything—individual stocks (including short selling and options), bonds, commodity futures, currencies, arbitrage, derivatives—whatever the fund manager sees as offering high potential returns in a short period of time. The focus of hedge funds is on maximum short-term profits.
Hedge funds are rarely accessible to the majority of investors; instead, hedge funds are geared toward accredited investors, as they need less SEC regulation than other funds. An accredited investor is a person or a business entity who is allowed to deal in securities that may not be registered with financial authorities. Hedge funds are also notoriously less regulated than mutual funds and other investment vehicles.
In terms of costs, hedge funds are pricier to invest in than mutual funds or other investment vehicles. Instead of charging an expense ratio only, hedge funds charge both an expense ratio and a performance fee.
Private Equity Funds
Private equity funds more closely resemble venture capital firms in that they invest directly in companies, primarily by purchasing private companies, although they sometimes seek to acquire controlling interest in publicly traded companies through stock purchases. They frequently use leveraged buyouts to acquire financially distressed companies.
Unlike hedge funds focused on short-term profits, private equity funds are focused on the long-term potential of the portfolio of companies they hold an interest in or acquire.
Once they acquire or control interest in a company, private equity funds look to improve the company through management changes, streamlining operations, or expansion, with the eventual goal of selling the company for a profit, either privately or through an initial public offering in a stock market.
To achieve their aims, private equity funds usually have, in addition to the fund manager, a group of corporate experts who can be assigned to manage the acquired companies. The very nature of their investments requires their more long-term focus, looking for profits on investments to mature in a few years rather than having the short-term quick profit focus of hedge funds.
1. Time Horizon: Since hedge funds are focused on primarily liquid assets, investors can usually cash out their investments in the fund at any time. In contrast, the long-term focus of private equity funds usually dictates a requirement that investors commit their funds for a minimum period of time, usually at least three to five years, and often from seven to 10 years.
2. Investment Risk: There is also a substantial difference in risk level between hedge funds and private equity funds. While both practice risk management by combining higher-risk investments with safer investments, the focus of hedge funds on achieving maximum short-term profits necessarily involves accepting a higher level of risk.
3. Lock-up and Liquidity: Both hedge funds and private equity typically require large balances, anywhere from $100,000 to upwards of a million dollars or more per investor. Hedge funds may then lock those funds up for a period of months to a year, preventing investors from withdrawing their money until that time has elapsed. This lock-up period allows the fund to properly allocate those monies to investments in their strategy, which could take some time. The lock-up period for a private equity fund will be far longer, such as three, five, or seven years. This is because a private equity investment is less liquid and needs time for the company being invested in to turn around.
4. Investment Structure: Most hedge funds are open-ended, meaning that investors can continually add or redeem their shares in the fund at any time. Private equity funds, on the other hand, are closed-ended, meaning that new money cannot be invested after an initial period has expired.
What Do the Experts Have to Say?
Elizabeth Saghi, CFP®
InAlliance Financial Planning, Santa Barbara, CA
A hedge fund is an actively managed investment fund that pools money from accredited investors, typically those with higher risk tolerances. Hedge funds are not subject to many of the regulations that protect investors as other securities, so they tend to employ a variety of higher-risk strategies for potentially higher returns, such as short selling, derivatives or arbitrage strategies.
A private equity fund is also a managed investment fund that pools money, but they normally invest in private, non-publicly traded companies and businesses. Investors in private equity funds are similar to hedge fund investors in that they are accredited and can afford to take on greater risk, but private equity funds tend to invest for the longer term.