Hedge Funds vs. Private Equity Funds
With minimum investments often surpassing $250,000, hedge funds and private equity funds attract high-net-worth individuals. They use pooled money and typically come in the form of limited partnerships. Besides paying basic management fees to the managing partners, their investors must give away a percentage of profits. The two, however, differ fundamentally in several aspects, including goals and types of investment. In addition, hedge funds and private equity funds entail different investment risks, structures, lock-up periods, and time frames.
An alternative investment vehicle, a hedge fund uses various strategies to generate returns for its investors. Hedge funds often use borrowed money or leverage to maximize their returns. Its primary goal is to realize the highest return for the shortest time. Thus, hedge funds predominantly invest in highly liquid assets that allow them to quickly generate profits from one investment and shift them into another, more immediately promising one. These can include individual stocks, commodity futures, currencies, derivatives, and practically anything their manager deems to have high and quick return potential.
Compared to other investment vehicles, hedge funds require far less regulation from the US Securities and Exchange Commission (SEC). Thus, they are accessible only for accredited investors. An accredited investor is a physical or legal entity authorized to deal in securities possibly unregistered with financial authorities.
Meanwhile, private equity funds resemble venture capital firms as they invest directly in companies. They mainly acquire private companies but occasionally obtain a controlling interest in publicly traded ones by purchasing stocks. Private equity funds tend to use leveraged buyouts to acquire companies in financial distress.
A private equity fund’s primary focus is on the long-term potential of its portfolio of companies. They aim at realizing profits on investments matured in several years. After acquiring or controlling interest in a company, private equity funds seek to improve it and ultimately sell it for profit. For example, they may change the management, streamline the operations, or expand it. The sale can take place either privately or via an initial public offering. To reach their goals, private equity funds typically have, along with the fund manager, a group of experienced corporate professionals, who they can entrust with the management of the acquired companies.
In terms of investment risk, both hedge funds and private equity funds manage risk by pairing riskier investments with safer ones. However, due to hedge funds’ focus on maximizing short-term profits, the level of risk is logically much higher. As for structure, most hedge funds are open-ended, which means their investors can add or redeem shares whenever they want. Conversely, private equity funds have a close-ended structure: investors cannot add money after an initial period has passed.
The different types of investments dictate different lock-up periods and liquidity for hedge and private equity funds. A lock-up period denotes a certain amount of time during which investors cannot transact with the shares in their investment. It enables the funds to distribute the pooled money within their investment strategy properly. Hedge funds’ lock-up period is shorter and can last from several months to a year. On the other hand, private equity funds’ lock-up period is longer and varies from three to five to seven years. The reason is the lower liquidity of private equity investments and the longer turnaround.
Finally, hedge funds operate in shorter time frames. Centered around liquid assets, they allow their investors to cash out their investments at any point. Contrarily, with the long-term focus of private equity funds, their investors must commit their assets for a minimum of three to five years and often up to to 10 years.
