What is the difference between a hedge fund and a private equity fund?
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.
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 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.
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 having the short-term quick profit focus of hedge funds.
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.
There is also generally 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.
There are hedge funds that fit the classic definition - funds designed to provide protection of capital invested in traditional investments - but that is no longer considered the common usage of the term.
There are several differences but the biggest I would say, is that hedge funds operate mostly in the public markets i.e. they make investments in securities such as stocks and bonds that are publicly traded in exchanges. On the other hand, private equity funds make private investments or buy publicly traded companies and take them private. (There are exceptions to the above, and some hedge funds do buy private investments and some private equity purchase public investments.)
There are other differences many arising because of the above difference: Hedge funds usually have a shorter time frame when making investments, their clients have a higher liquidity i.e. they can take their money out faster than from a private equity fund, hedge funds usually buy only a fraction of a company whereas private equity funds usually buy entire companies then improve their operational and financial performance, hedge funds may have a slightly different fee structure than private equity funds etc.
Here is a presentation on introduction to hedge funds that I made: Click here
Private equity is the investment capital invested by any high net worth individual in a firm with the aim of acquiring equity ownership in the firm. These capitals are not quoted on a public exchange. The capital can be used for expanding the working capital of the company, to strengthen the balance sheet or to bring new technology in the company to increase output. Institutional investors and accredited investors are the major part of the private equity in any company because they have the ability to commit a large sum of money for a longer duration of time. Often, private equity is used to convert a public company into private one.
Whereas a Hedge Fund is another name for an Investment Partnership. The meaning of the word ‘hedge’ is protecting oneself from the financial loses thus Hedge Funds are designed to do so. Although a risk factor is always involved but it depends on the return. More the risk, higher is the return. Hedge funds are alternative investments done by pooling funds involving a number of strategies to earn high returns for the investor. Hedge funds are not regulated by SEC and can be used for a range of securities as compared to mutual funds. Hedge Funds work on the Long-Short strategies which mean investing in long positions i.e. buying stocks as well as short positions which mean selling stocks with the help of borrowed money and then buying them again when the price is low.
A hedge fund is a privately managed investment vehicle, typically structured as a Limited Liability Partnership (LLP), that has a broadly-stated investment mandate and the ability to invest in a wide range of relatively liquid financial instruments (ranging from long and short equity positions to futures and options on commodities, interest rates, currency pairs, volatility levels, market indexes, and more). Additionally, some hedge fund strategies focus primarily on debt/credit markets, while others focus primarily on taking advantage of unique knowledge with respect to anticipated macroeconomic, market, or company-specific events (Event-Driven strategies).
Unlike hedge funds, private equity funds hold illiquid positions (for which there is no active secondary market) and typically only invest in the equity and debt of target companies, which are generally taken private and brought under the private equity manager's control.
While the private equity investor looks at an investment prospect as investing in a company, hedge fund managers often look at equity positions as investing in the company’s stock (whose performance has its own, unique set of drivers). A company's success is determined over the long-run by the performance of its products, its business model, and whether it can develop a sustainable competitive edge. A stock's success often diverges from the company's fundamental performance, especially in the short-to-medium term, due to behavioral biases, irrational behavior among investors, emotional decision-making, market hype, and supply and demand imbalances in the market for the company's shares (i.e. varying liquidity conditions).
Hedge funds typically allow quarterly redemptions, giving their managers a shorter-term mindset (generally speaking, though there are notable exceptions to this) than a private equity fund manager. The private equity manager receives capital commitments that cannot be withdrawn for a standard ten-year term (often with a two-year extension available at the General Partner’s discretion). This partially explains hedge funds’ tendency to focus more on the short-term, as they face the threat of large redemptions, even if they only underperform for a single quarter.
Similar to hedge fund structures, private equity funds often organize as an LLP, but the Limited Liability Companies (LLC) structure is also common. Both hedge funds and private equity funds typically charge a management fee against total assets under management (AUM), ranging from 1%-3% of invested capital, and take a profit share called “carried interest” or “carry,” which ranges from 20% (by far the most common) to 30% (rare). With carried interest, suppose a hedge fund began operations with $100 million AUM at the start of 2015 (1/1/2015), and had no contributions or withdrawals during the year. If the fund’s Net Asset Value (NAV) rose to $130 million at the end of the year, the fund manager would be entitled to carried interest of $6 million (20% x $30 million profits). If the fund subsequently loses all profits earned and more throughout 2016, the fund manager likely will not receive any carried interest due to high-water mark provisions (not applicable to private equity).
A hedge fund is an actively managed investment fund that pools money from accredited investors - those who can afford to take a higher than normal risk. Hedge funds are not subject to many of the regulations that protect investors so they can employ a number of different strategies to achieve higher returns. They can invest or trade in all sorts of securities, take long or short positions, use alternative investments such as derivatives, or employ risk arbitrage strategies. Hedge fund investors are mostly high net worth individuals, pension funds, insurance companies, banks and endowment funds. Hedge funds normally charge an annual management fee of 1 or 2% as well as 20% of the profits.
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. The investment managers of a private equity fund invest the money for a longer period of time than hedge fund managers. Therefore, the private equity investor's money is not as liquid and returns are achieved when the investment is sold or goes public.
Investors in Hedge Funds and Private Equity Funds are mostly required to be accredited investors requiring minimum investments of $250,000 or more. Whereas Hedge Funds mainly invest in securities in liquid markets having greater liquidity and greater risk for investors to attain high potential returns in a shorter period of time from the use of stocks, bonds, commodities, futures and options exchanges. The Private equity fund invests in privately negotiated transactions through venture capital firms acquiring financially distressed companies utilizing leveraged buyouts which requires a long term focus with limited liquidity.
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All the very best to you,
Jan Attard, Realtor, MBA