What is a “Hedge Fund vs. Private Equity”?
While both hedge funds and private equity funds appeal to investors with similar risk profiles, mostly wealthy individuals or institutional investors, the two investment types have very distinct differences. Hedge funds often employ sophisticated strategies and allocate money to exotic investments, whereas private equity funds seek to acquire private companies and sell them at a profit either to another private equity entity or through an initial public offering (also called a liquidity event). In terms of structure, both are pooled vehicles, but some hedge funds may be open-ended, while private equity funds are typically closed-ended. On the other hand, some of the similarities include lock-in periods and risky investment strategies.
Key Learning Points
- High net worth individuals and institutional investors are the typical client base for both hedge funds and private equity funds
- Both are pooled investments, but may differ in their structure – some hedge funds could be open-ended, while private equity funds are often closed-ended
- In terms of benefits, both can offer diversification relative to traditional asset classes, along with high upside potential
- While some hedge funds might target short-to-medium term profits, private equity funds have long-term time horizons
Hedge funds are classified as alternative investments and can invest in a variety of sophisticated instruments like derivatives and commodities, along with traditional ones such as equities and bonds. Hedge funds are less regulated (if at all) than traditional funds and therefore can undertake high-risk investment strategies. Hedge fund managers employ a multitude of higher-risk investment techniques e.g. short-selling and using leverage and arbitrage trading. By pooling significant amounts from investors into a fund, they can employ economies of scale and high-risk investment strategies to achieve a rate of return that is higher than the market average.
Private Equity Funds
The main objective of private equity funds is to achieve high returns over the long term. They would typically seek to acquire private companies or buy a controlling stake in publicly traded entities in order to have enough influence over their management. In fact, restructuring the management, improving the business model and operations are among the tools private equity funds have at their disposal. Private equity funds usually target companies that are financially struggling and use these techniques to turn them profitable. The potential exit routes include selling the company to another company or listing it on the market through an initial public offering. Similar to hedge funds, private equity funds have lock-in periods, which could be quite long (for example, three, five, ten, or more years) due to their illiquid nature.
It is important to mention that diversification and the potentially high returns come at a cost. Both hedge funds and private equity funds typically charge investors a management fee and performance fees, which could be quite hefty. In addition, investors should bear in mind that private equity is relatively illiquid and generally would require longer lock-in periods than hedge funds, during which access to money is restricted.
Below is a multiple-choice question to test your knowledge, download the accompanying excel exercise sheet for a full explanation of the correct answer.