The world of finance offers a high variety of investment vehicles for investors to choose from. They all differ in the strategies they are employing, the risks that are undertaking, and the returns that can deliver. Private equity and hedge funds are often discussed as alternative investments to exchange-traded funds and mutual funds, offering the potential for higher returns but with distinct investment strategies and risk and return characteristics.
The main difference between private equity funds and hedge funds is the type of investments they make. Private equity firms invest in private companies and cooperate with them to make them more profitable. Hedge funds on the other hand use one or more complex investing strategies to maximize potential gains.
From that first difference, come a whole set of unique characteristics that sets these investment vehicles apart. Among others, there are questions about investment strategies, company structure, and liquidity of investments. And once you know the answer to these questions you can find a better investing platform for your needs.
Key Takeaways
- While hedge funds focus their investments on publicly traded securities, private equity firms invest in the private sector.
- As a way to diversify their operations, hedge funds had taken an interest in private equity, and sometimes share the market with private equity firms.
- Hedge funds and private equity firms share a number of similarities, like manager fees, regulatory scrutiny, and legal structure.
- The average hedge fund delivers 6% to 10% annual returns, while the numbers for private equity firms are a bit higher, between 10% and 15%.
- When comparing hedge funds to private equity, both allow investors to pool their money and invest in various assets such as stocks, bonds, and real estate.
Defining Private Equity
Private equity firms base their operations through investing in privately held companies. To achieve this, private equity firms utilize several strategies, including leveraged buyouts, growth capital, and investing in distressed asset classes.
The primary goal of private equity firms is to acquire a significant stake in the company they are targeting, work with the management to improve overall operations, and later sell them for a profit.
Private equity investing is characterized by a longer investment horizon. In most cases, this period is between 5 and 10 years. This is necessary because it takes time to make a company profitable enough to be able to sell it for a good enough profit margin.
Due to their approach to investing in significant chunks of ownership, private equity firms prefer to take the active management road. They work together with the managers and executives in bought firms to make them better and raise their value.
Defining Hedge Funds
Hedge funds are alternative investment companies that pool investor capital and reinvest it to generate higher gains. Hedge fund managers employ diverse investment strategies to get the best out of their investment picks.
One thing that pushed hedge funds out as a unique investment vehicle is a chance to create a highly diverse portfolio. Hedge funds invest in a wide array of asset classes - private and public equity, bonds, commodities, material, real estate, and currencies just to name a few. They employ leverage to boost their returns, at the same time increasing their risks.
Unlike mutual funds and other investment vehicles, hedge funds aim to win big. In that manner, they are not comparing themselves with indexes, but are attempting to beat them. Depending on the strategy, they are looking for short or long-term gains.
Even after several scandals that included insider trading, fraud, and unethical behavior, they are still lightly regulated by the regulatory bodies. When comparing them to equity firms, ETFs, and mutual funds, they do not need to keep their investors informed about every decision they make.
What information will they share with the public depends on their judgment. They usually prefer to publish quarterly or annual letters in which they will share some details about performances, certain investments, and potential future plans.
In any case, investing in hedge funds is not for those with thin nerves. Often high-risk with long redemption periods, this is an investment play for those who are ready to wait out their often high gains.
Fund Structures
Hedge Fund Structure
A hedge fund is legally structured as either a limited partnership or a limited liability company. Limited partnerships are the preferred legal structure for alternative investment funds in the United States. The responsibility for operation is divided between a general partner and a limited partner. The general partner has unlimited liability and takes responsibility for managing the fund, while limited partners take their share of responsibility, depending on the capital invested.
Limited liability companies are also a popular way to structure a hedge fund, due to flexibility in management operations, and the benefits of pass-through taxation.
Private Equity Fund Structure
Similar to hedge funds private equity firms are structured either as limited partnerships or limited liability companies. They have the same internal structure and responsibilities as hedge funds.
Investment Strategies
Private Equity
Private equity does not have the same strategy diversity as hedge funds, but they have enough tricks in their sleeves. Some of the typically utilized private equity strategies are:
- Venture capital: identifying startups in the early stages of development that show great potential for future growth.
- Growth capital: investing in already developed companies that need fresh capital to improve their operations.
- Distressed investments: high-risk investments into companies in financial distress or undergoing bankruptcy. The aim is to make these cheap but risky investments into high-valued companies and earn a profit.
- Leveraged buyouts: an investment approach where companies combine their capital with borrowed assets to make an investment claim.
A private equity fund manager must limit investments to specific sectors, and the importance of capital commitment is crucial as failure to honor the capital call can result in severe penalties.
Hedge Funds
Hedge funds are characterized by a number of alternative investment strategies they can utilize to maximize gains. Depending on the fund they can specialize in one strategy, or they can run a diversified strategy fund aiming to earn from multiple strategies. Hedge funds tend to use their manager's expertise in certain approaches and to find several ways to increase their gains. The most popular hedge fund strategies are:
- Long/short equity: this is a strategy where fund managers aim to benefit from both directions that the market can take. They take long positions in companies that are expected to rise and short positions in underperforming assets.
- Global macro: funds that focus on these strategies oversee the developments in the markets all over the world. They look for potential events that can trigger the sector, market, or company to go in a certain direction. They focus on financial and capital markets that they know best and make their bets on further developments.
- Event-driven: managers follow certain companies or sectors and wait for the corporate events from which they can profit. It can be a merger of two or more firms, bankruptcy, restructuring, or a similar event that can result in a price fluctuation in the short term. Fund managers wager their opportunities and make bets on the future of the endeavor.
Liquidity
Private equity investments by their nature are illiquid. One of the key reasons for their illiquidity is that private companies do not have financial markets available for their shares. That is why private equity firms aim to make private companies better and later sell them for a better price.
Another option is to offer the company through the initial public offering (IPO). This is the first step in moving the company from the private to the public sector. Through it, the company can raise equity capital from public investors.
When talking about liquidity and hedge funds, is a bit more complex topic. Some hedge funds, depending on the strategy will invest in more liquid, while others will opt for illiquid assets. The majority of hedge fund investments are liquid because they are investing in publicly traded assets.
Group of liquid assets include government bonds, publicly traded stocks, and exchange-traded derivatives. Illiquid assets include real estate, distressed debt, and private equity.
Hedge funds usually practice a so-called lock-up period, when investors cannot redempt their investment. How long the lock-up period will last depends on the liquidity of assets they invest into, and their redemption policy.
Regulatory Environment
Both investment vehicles are under the authority of the Securities and Exchange Commission and under the Investment Advisor Act of 1940.
There are differences in the regulatory scrutiny that is essentially targeting different aspects of operations.
Regulatory bodies when checking hedge funds are focused on trading practices, fee disclosures, and fiduciary duties to their clients. This comes as a result of hedge fund trading practices, and often heavy use of leverage.
On the other hand, private equity firms are put under the scanner regarding valuation practices. Also, they are checking on fiduciary duties and fee disclosures regarding managing portfolio companies.
Fees
Hedge funds are known as high-fee investment vehicles. Their typical fee structure is 2/20 where 2% represents the amount that managers take from the total assets under management. The 20% segment is a performance fee that managers earn in case they deliver higher returns than the previously set benchmark. Private equity fund managers also follow a similar fee structure, with annual management fees and profit-sharing models.
After decades of the same fee policies, things started to change. In the 21st century changes in the fee structure were forced due to the high competition amongst funds. After the great economic crisis of 2008 performance of hedge funds was pushed to its limits. They couldn’t deliver gains to justify the fees, which resulted in opting for lowering fees.
Private equity firms have in reality very similar fee structures as hedge funds. The 2/20 fee structure is there, however, depending on the firm, it can be lower, often reaching 1/10.
Investor Base
Hedge funds are regarded as the investment vehicle for the rich. Both individuals and institutional investors must have substantial capital worth to be considered as potential investors in hedge funds. Both, individual and institutional hedge fund investors must be accredited. Accredited investors are those that fulfill certain predispositions like level of annual earnings ($200.000 per year) or net worth (at least $1 million).
Also, since hedge funds are utilizing complex and risky strategies, that heavily rely on risk management, it is advisable for the investors to have an economic background. Using financial advisors is a legitimate option. Institutional investors, usually, include endowments, pension funds, wealth funds, and insurance companies. Also, fund of funds are regular investors in hedge funds and find it a great way to diversify their portfolios.
Just like with the fees, hedge funds and private equity share a similar investor base. Among their investors are both high net worth individuals and institutional investors. Like with hedge funds, investors must be accredited.
Besides institutional investors like pension funds and insurance companies, family offices frequently opt to invest in private equity.
Recently retail investors also found that private equity firms are a great option to diversify their investment portfolio.
Expected Returns
When looking at the recent hedge fund industry and its performance, expected returns are in the range of 6% to 10%. This can significantly vary for several reasons. The experience and knowledge of the portfolio managers, the strategy they use, and reliance on leverage are just some factors that impact returns.
Private equity firms are dealing with illiquid assets which brings another dimension into play. Investors in illiquid assets can count on illiquidity premium as a reward for choosing long term investments that are highly illiquid.
Hedge fund investors can be forced to wait out their investment gains which depends on the strategy involved, however, with private equity that is a must. These investments cannot be short-term, and investors must be aware that they will have to wait for prolonged periods. On the other hand, private equity firms usually deliver higher gains than hedge funds, often in a range between 10% and 15%.
Closing Remarks
You must be wondering what is the right way to invest between these two vehicles. Answering this question demands analyzing your needs and preferences.
Hedge funds bring the thrill and high risk of investing that we often see in movies with the Wall Street topic. They can bring you the highest returns in the industry, but also you can lose everything. What is good about them is that they offer variety, and almost everybody will find a strategy or an approach in the hedge fund industry that suits them.
The private equity market is an illiquid market that forces investors to wait out their investments. They come with a bit less risk, and can also be highly rewarding. The only thing that the investors should think about is whether are they ready for a long wait.