Hedge funds and private equity funds often attract investors of the same type. However, the goals of hedge funds and private equity funds and the type of investments the fund managers seek are different. Private equity funds and hedge funds appeal to investors with a higher net worth; many of these funds require a minimum investment of $250,000 or more. Also, each has basic management fees and requires that a percentage of the profits be paid to the managing partners as they are typically structured as limited partnerships. Let’s examine these differences in-depth, and you can determine which is right for you.
What Are Hedge Funds?
Hedge funds are an investment that uses pooled money to purchase various financial instruments and utilize different tactics to garner returns for their investors. To achieve these quick returns, a hedge fund manager will look towards highly liquid financial assets to get a quick return on their investment and rapidly switch to another more promising investment in the short term.
Hedge funds typically use borrowed money, or leverage, to further increase their returns. This is a precarious endeavor. If the hedge fund manager is wrong and the investment tanks, the borrowed money is still owed, but there are no funds to pay it back. No investment medium is off-limits to a hedge fund manager as hedge funds can consist of any investment such as bonds, currencies, derivatives, arbitrage, commodity futures, individual stocks, including shorting and options, in addition to directly buying stock. Whatever investment looks promising for a quick return, the hedge fund manager will capitalize on it.
Hedge funds are typically off-limits to an average investor as they’re subjected to less regulation by the Securities and Exchange Commission. As a result, hedge funds are usually only available to accredited investors who can buy and sell securities not registered with any financial authority. Hedge funds are significantly less regulated than other investment vehicles such as mutual funds. Hedge funds are more expensive than mutual funds or other financial instruments. As opposed to charging only an expense ratio, hedge funds will charge the expense ratio along with a fee based on performance.
What Are Private Equity Funds?
Meanwhile, private equity funds feature a direct approach in investing in individual companies by either purchasing a controlling interest, in the case of a publicly-traded company, or purchasing the firm outright in the case of a private company. In that regard, private equity funds are more akin to venture capital firms. Private equity funds often utilize leveraged buyouts to procure companies that are under duress or in financial trouble.
Private equity funds are the antithesis of hedge funds because they look for long-term potential in their investment vehicles. They look for investment opportunities that provide a significant return on investment (ROI) over a long period. After either acquiring outright or obtaining the controlling interest in a company, a private equity fund will look to increase the company’s value through various improvements such as streamlining operations, changing the management team, or even expansion to add profitability.
The goal of a private equity fund is to ultimately sell the company, or their controlling interest, at a significant profit. In the case of a privately owned company, they can either sell it outright or offer an initial private offering (IPO) and take the company public, selling their interest in this fashion. A private equity fund will typically consist of the fund manager and a contingent of corporate experts who manage the newly acquired companies. The investments sought inherently require a more long-term focus simply due to the nature of buying and turning around a company for eventual profit.
What Is the Difference Between Private Equity Funds and Hedge Funds?
Investors will find several differences between private equity funds and hedge funds, such as investment time, risks, liquidity, and the overall structure.
Investment Time Horizon
The first significant difference between private equity and hedge funds would lie in the investment time horizon. Hedge funds will look for investments that will quickly provide a good ROI within a relatively short time. Managers of hedge funds typically seek liquid assets to allow for quickly jumping in and out of investments.
Conversely, private equity funds are looking for investments that generate large returns over a more extended time than short-term investments. A hedge fund will operate in a time frame that can be from a few seconds up to a year, although typically less, while the minimum period required in a private equity fund investment usually starts at three to five years and can often go up to seven to 10 years.
The risk tolerance for each of these investments also lies in stark contrast to one another. By their very nature, hedge funds are much riskier simply because the short-term high reward is usually tied to a much higher risk. Both will practice risk management which balances the higher-risk investments in their investment portfolio with safer ones. Safer investments in a hedge fund still carry much more risk than a safer investment in the private equity fund portfolio.
Liquidity and Locked Funds
A similarity between a private equity fund and a hedge fund is that they typically have a very high entry cost, from $100,000 to several million dollars per investor. A hedge fund will then lock those funds up for a predetermined period, usually several months up to a year, in which the investor cannot remove their funds. This time is needed to ensure the hedge fund has the requisite time to carry out its investment plan.
A private equity fund also has a lock-up period that would be much longer and could be three, five, or even seven years. The longer time frame is necessitated by the non-liquid nature of these investments and the time needed to rebuild the companies.
Structure of Investment
A hedge fund is typically open-ended, meaning that investors can continue to purchase additional shares at any time. Conversely, a private equity fund is usually closed-ended, which means there is a window of opportunity in which investors can invest in the private equity fund. When that window expires, no more shares can be purchased.
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