Hedge funds and private equity funds are pooled investments that offer high investment returns to investors.
Both types of funds seek similar investment goals with contrasting tactics.
Let us discuss what are hedge funds and private equity funds and their key differences.
What is a Hedge Fund?
Hedge funds are pooled investments that seek high investment returns through active management.
Hedge funds require large initial investments. They are set up as limited partnerships and are available to worthy individuals.
Hedge funds are actively managed investment funds. The success and the reputation of hedge funds depend largely on the fund manager and the investment strategies implied.
Hedge funds are a costly investment overall. These funds require a large initial investment starting from $100,000 onwards for each investor.
Hedge funds also charge a significant fee of 1-2% of assets and around 15-20% of performance fees of the fund.
High risks associated with hedge funds come with higher rewards as well. Investors look for above-average returns by seeking active investment strategies.
How Does a Hedge Fund Work?
Theoretically, hedge funds are used to hedge an investment fund from different types of risks. Typically, an investment fund would allocate a fraction of the total investment in the opposite investment direction to hedge against several types of risks.
In recent years, hedge fund managers have adopted a different strategy of applying active investment strategies. They seek a higher return on investment through the available hedge funds rather than only diversification.
Hedge funds look to make quick profits. Therefore, these funds are held in the form of highly liquid assets. The investment span of the targeted investment is also short usually.
Hedge target several types of asset classes that offer quick and high investment returns. Hedge funds invest in stocks, cryptocurrencies, bonds, forex, commodities, and derivatives to name a few classes.
Hedge fund managers would look to invest in any type of asset that offers returns close to their target. They aim to generate short and quick profits.
Hedge funds may invest in several types of assets within a short time as well. They would look to liquidate the investment from one asset class and invest in another when prospects are good.
Hedge funds typically rely on borrowed money as well. It means their target return on investment would further increase as they must recover borrowing costs as well.
Despite using borrowed money, hedge funds are not accessible to retail investors. They require high initial investments that only a few selective investors can offer.
What is a Private Equity Fund?
Private equity funds are set up through private firms that invest in companies that are privately held.
Private Equity (PE) funds are similar to venture capital firms. These firms are set up in the form of private companies and look for investments in companies with high growth prospects.
Since PE funds invest in growing companies, they need time to realize gains on investments. Thus, unlike hedge funds, PE funds look for long-term investment goals.
PE funds are also actively managed by fund managers. In fact, PE funds also imply a team of corporate experts that help fund managers in making key decisions.
PE firms seek active participation in managing the investee company’s affairs.
How Does a Private Equity Fund Work?
PE funds acquire controlling interests in a private company through large investments. Like hedge funds, private equity funds also require high initial investments.
PE firms arrange investment funds through pooled investments from high-worth individuals and private companies looking for private investments.
Once a PE fund acquires control, it looks to make the company profitable. They involve in management decisions and make drastic changes as and when needed.
Unlike hedge funds, PE funds require more time to realize their target return on investment. A PE fund may require from three to five or even ten years to realize investment returns.
Since these funds also imply significant resources, they’ll incur high investment costs and management fees. Therefore, they’ll target high investment returns in the long run.
The exit plan of a PE fund is usually through an initial public offering (IPO). However, if the company cannot be listed publicly, a PE fund may be liquidated through selling the controlling interests privately as well.
Either way, the PE fund aims to sell the company when it is profitable and generates a good return on selling the controlling interests.
Hedge Fund Vs Private Equity Fund
Hedge funds and private equity funds offer similar investment returns but with varying strategies and investment risks.
Here are a few key differences between both types of investment funds for investors and managers.
Legal Investment Structure
Hedge funds are designed to remain open-ended throughout. It means new investors can invest or existing investors can withdraw their investments at any time.
An open-ended investment structure offers further flexibility to the fund manager. New investment resources can be added at any given time to maintain the performance and investment targets of the fund.
On the other hand, private equity funds are closed-ended. It means once a PE fund is invested, new investors cannot be added to the investment pool.
It also means that interests in a PE investment cannot be transferred to another party until the initial period expires.
Hedge funds look for quick and short-term profits. They hold highly liquid assets and also look for highly liquid investments.
Therefore, hedge funds only target short-term investments that typically range from one month to one year.
Contrarily, private equity funds invest in private companies. They aim to turn around a company’s performance or improve the existing one.
Therefore, the investment span of a PE fund would typically range from three to seven or ten years.
Also, the exit plan of a PE fund may take time to realize as well. Unlike a hedge fund, the PE fund does not liquidate quickly.
Hedge funds seek short and quick profits. They imply active and aggressive investment strategies to realize their investment goals.
Without a doubt, hedge funds offer more risk than PE firms. Hedge funds also come with higher management costs overall. Therefore, they require a higher return on investment as compared to PE funds.
PE funds do not come risk-free either. However, since a PE fund controls the private company, it can control the level of risk somewhat.
Also, a PE fund has more time to make the investment profitable. Therefore, they offer a lesser degree of risk as compared to hedge funds.
Liquidity and Lock-up Periods
Hedge funds hold more liquid assets in their investment pool. These funds require a high initial investment but these investments are in cash or highly liquid asset forms.
The lock-up or investment holding period for a hedge fund range from one month to one year which is typically the span of total investment as well.
Although PE funds are also liquid, they offer a few constraints. The lock-up period for a PE investment is far longer than a hedge fund.
Investors have to hold their investments in a PE fund for around three to seven years typically. They also have to go through an investment exit plan such as an IPO to liquidate their investments.
When it comes to paying taxes, both types of funds need to comply with the IRS requirements similarly.
Hedge and PE funds need to report their short-term profits, losses, dividends, and long-term capital gains for tax purposes to the IRS.
Capital gains taxes apply to hedge funds mostly as they seek short-term returns. Therefore, PE funds can avoid the higher capital gains by holding the investment for the long term.
Return on Investment
The management costs and risk factors of hedge funds require a higher return on investment. These are short-term investments that invest in risky asset classes to generate a higher return on investment often.
On the other hand, a PE fund requires a consistently growing return on investment that meets their target in their investment span.
Control Over Assets and Participation
Hedge funds fully own the assets they hold partially or fully. For instance, a hedge fund may hold stocks of a blue-chip company that gives them shareholding rights.
However, hedge funds do not look for controlling interests. They consider the management of the hedge fund only. They have no active participation in the management affairs of the company they invest in.
On the other hand, a PE fund seeks controlling interests in the company. They retain these controlling interests for the investment period until liquidation.
PE fund managers and their executive team participate in the management decisions actively. They target an improved performance by implying different tactics or improving the existing ones.
Therefore, a PE fund holds larger controlling interests but is less liquid as compared to a hedge fund.