Hedge fund vs private equity: How do they differ?

Hedge fund vs private equity: How do they differ?
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Hedge funds and private equity funds both are popular alternative investment vehicles. They both appeal only to high net-worth individuals. Most PE firms and hedge funds require a minimum investment of $250,000 or more. So, they approach only accredited investors to attract investment. Both hedge funds and private equity funds are typically structured as limited partnerships. Despite these similarities, they still have a number of differences. In this hedge fund vs private equity comparison, let’s find out how they differ.

In the last few years, wealthy investors are increasingly pulling their money out of hedge funds. And they are allocating more cash to private equity. According to the 2019 EY Global Alternative Fund Survey, hedge funds accounted for 33% of institutional investors’ allocation to alternative investments, down from 40% in 2018. In contrast, private equity jumped from 18% in 2018 to 25% in 2019.

Separately, data from the U.S. research platform eVestment shows that investors pulled out a staggering $98 billion from hedge funds in 2019. That’s still minuscule compared to the $3.3 trillion of assets under management (AUM) of hedge funds at the end of last year.

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Hedge funds

Hedge funds are actively-managed alternative investment vehicles that pool money from wealthy individuals and institutional investors. Investors putting their money in hedge funds tend to have a high risk tolerance.

Hedge funds aim to generate positive returns for their investors in both bull and bear markets. Their strategies are designed to protect the portfolio from the uncertainties of the market. Most hedge funds employ both long and short strategies. Sometimes they also use leverage to boost returns. They invest in a wide range of securities including stocks, bonds, commodities, derivatives, and currencies.

In recent years, they have been using complex algorithms and analytical practices to generate alpha. Unlike banks and mutual funds, hedge funds are loosely regulated. It enables them to employ high-risk strategies to deliver positive returns.

Hedge funds chase short-term profits. They aim to provide the highest possible returns in the shortest period of time. That’s why they invest in highly liquid assets. Once they book profits in one opportunity, they move their money to the next and hopefully more promising opportunity. Hedge funds charge ridiculously high fees, and so do the private equity firms.

Private equity

Just like hedge funds, private equity firms pool money from accredited investors with relatively high risk tolerance. They invest primarily in privately-held companies and businesses. Sometimes, they acquire controlling stake in publicly-listed companies and take them private. They also use leveraged buyouts to purchase financially distressed companies.

Private equity funds typically take a long-term view on their investments. Once they invest in or acquire controlling stake in a company, they focus on improving its performance and valuation. They achieve it by changing the management, expanding operations, improving efficiency, or other measures. And then they sell the company (or their stake in it) for a handsome profit.

Most large private equity firms have an in-house team of corporate experts. After the fund manager has acquired a company, the corporate experts could step in to guide or manage its operations. It’s a long-term process, taking several years to reap the rewards for investors. Investors putting their money in a private equity fund commit to stay invested for a specified period of time, which could range from 3 years to 12 years.

Hedge fund vs private equity: Key differences

Hedge funds are open-ended investment funds. There is no restriction on transferaility of funds. Investors can cash out their investments at any time. In contrast, private equity funds are closed-ended, meaning there are restrictions on transferability for a specified period. It’s also difficult to determine the current market price of your investment in private equity.

Another major difference between the two is in terms of time horizon. Hedge funds have a much shorter time frame, which could be anywhere between a few seconds to a couple of years. The investment horizon of private equity funds varies between three years and 12 years. The PE fund manager can also extend the investment period if they get the consent of all investors.

They also differ in the way you can invest. Those planning to invest in hedge funds can invest their money in one go at any time. But if you want to invest in a private equity fund, you have to first commit to invest a specified amount in a future deal the PE fund would make. Your money will be invested only when called upon. And you have to stay invested for several years.

There is also a significant difference in their level of risk. Both hedge funds and private equity funds invest in high-risk bets. But they also try to mitigate the risk with some safer investments. The risk is still a little higher in hedge funds because of their obsession with high returns within a short time frame.

Hedge fund vs private equity: Fee structure

Now let’s talk about costs. Both hedge funds and private equity funds have notoriously high costs. Private equity funds charge investors a flat 1.5% or 2% management fee and 20% performance fee. Fortunately for investors, the PE funds have a hurdle rate.

If the annualized returns are lower than the hurdle rate, the private equity fund won’t charge the performance fee. If the returns turn out to be higher than the hurdle rate, it will charge 20% performance fee on the gains.

Hedge funds also have a similar fee structure, where they charge 2% management fee and 20% performance fee. Unlike PE funds, hedge funds earn performance fees even if your gains are as low as 1%. There is no hurdle rate. In recent years, hedge funds have been under pressure to cut their fees, especially when they have consistently under-performed the S&P 500 index.

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