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 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.
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.
I will try not to repeat what the other advisors have already provided in their responses, but will add a few caveats to the conversation.
The term hedge fund has evolved from the early days when hedge funds actually hedged their positions as compared to the general markets. Today, though, hedge funds are private investment funds that follow a variety of strategies (Global Macro, market neutral, Long/Short, commodities, etc.), many using leverage in order to generate outsized returns (many times with outsized risks) versus the market. In many ways, they are less-regulated mutual funds with higher fees. Their performance across time has been shown to be relatively average (with high costs) and many large institutions have begun to pare back their exposure to the funds.
Private equity funds are usually pooled limited partnership vehicles used to make investments in private companies. The industry has grown dramatically over the last 20 years with firms like KKR, Bain Capital, Blackstone, The Carlyle Group, and others dominating the upper end of the market and many have gone public to access longer term funding at a lower cost than in the private markets. Private equity investors tend to specialize on an industry segment, geography, company size and/or type of transaction (distressed, turnaround, growth, etc.). LPs have historically been university endowments, pension plans, insurance companies, foundations and family offices.
The main differences between the two fund types are that hedge funds tend to invest mainly in securities in liquid markets and have greater liquidity for their investors, while private equity funds invest in privately negotiated transactions with private companies and have limited liquidity for their investors during the holding period of the assets. There is a growing secondary market for private equity LP units that makes it easier to sell an LP unit at a point in time, but it is still a negotiated market with private buyers and sellers. Also, while certain hedge funds may build concentrated portfolios, they tend to hold many more investments, and have much higher leverage than a typical PE fund. PE funds, on average, hold anywhere from 10 to 20 investments and employ leverage at the operating company level, as compared to holding leverage at the portfolio level, as do many hedge funds. This actually reduces the risk of a portfolio implosion at a PE fund as compared to a hedge fund, because the PE debt is secured on a company by company basis and is thus compartmentalized, where as debt in a hedge fund is backed by all of the fund assets.
Both types of investments can be diversifiers for large sophisticated investors, but are generally not appropriate or necessary investments for smaller investors due to high fees and mediocre performance.
A hedge fund "hedges" (i.e. makes shrewd guesses) over a publicly traded security, a group of securities, or the market and buys positions with the idea of a relatively near term gain. Hedge funds are traders at heart, looking for existing or anticipating anomalies or discontinuities in the market's pricing of securities.
A private equity fund takes investment positions in companies with the anticipation of a longer term return when the company goes public or is eventually sold. Private equity firms are investors and not traders.
Two different types of high risk investing. While there are always stories of a particular hedge fund or private equity fund doing well, it is usually the management of those funds that reap the benefits, not the investors, due to incentive compensation paid by the managers and the fact that each vehicle must make a lot of investments that will inevitably turn out to be loser. The trick is to have one or two "whales" that offset all the losers. The investors share in the whales, minus the losers, after management compensation.