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.
The Advisor Insight
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.
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Santa Barbara, CA