Hedge funds and private equity funds are both grouped under the “alternative investments” wagon, but there are key differences in the way each of these investment options operates. Hedge funds employ investment strategies across different asset classes with the aim of earning quick profits. Private equity funds, on the other hand, invest in ailing businesses with the aim of transforming them and earning returns from their sale or rise in stock price.
Here are the key differences between the two investment options:
Hedge funds are run by investment professionals with great experience in market trading. The professionals traverse financial security markets searching for opportunities that can make the best profits. They take high risks and invest in securities such as bonds, stocks, derivatives, and commodities that are traded in the open market and can be bought and sold on short notice to generate high profits.
Private equity firms invest in businesses by purchasing select assets in them or by purchasing them in whole. Their fund managers often target troubled firms and use their expertise and resources to turn around the fortunes of the ailing firm. Eventually, they seek an exit strategy from the acquired firm by selling it or pursuing an initial public offering.
Liquidity represents an investor’s ability to access their cash. Hedge funds are open- end funds, meaning that as long there is adequate capacity, investors can invest or redeem their earnings in accordance to the fund’s settings. Some funds allow capital withdrawals daily, while most only allow monthly, quarterly, or yearly withdrawals depending on the liquidity of the underlying assets.
Private equity funds are close-end funds, and this shows in their long-term investments in much less liquid assets. The fund’s securities are non-redeemable, and all committed investors are locked into the fund until its materialization, typically in 5-12 years.
3. Money Commitment from Investors
With Private equity funds, you don’t invest your money into the fund immediately. Instead, you commit that a certain amount of money will be paid to the fund in the near future when a deal is available to the portfolio managers in the private markets. Investment opportunities here arise unpredictably and therefore there is no fixed time duration as to when your money will be called upon.
When you invest in hedge funds, however, your money will leave your bank immediately and be invested in marketable securities traded in real time.
4. Performance Measurement and Realization
How a Private equity fund performs is measured in terms of IRR (Internal Rate of Return), and a minimum “hurdle rate” (prescribed minimum return to security holders) applies. Its performance realization is generally after the hurdle rate has been achieved, and this typically happens in the later years of the fund’s investments.
Hedge fund returns are measured according to a benchmark, and their performance is realized continuously as the portfolio manager invests in security markets in real time.
Private equity and hedge funds both earn annual fees; usually 1-2%, on the assets managed, and in addition receives performance incentive fees in the range of 20% on profits earned. However, incentive compensation fees with hedge funds are governed by a concept referred to as the “high-water mark,” while those in Private equity are governed by the “hurdle rate.”
Hedge fund managers only receive incentive fees (20% of profits) when the fund exceeds an investor’s highest net-asset-value (NAV) to date, commonly referred to as the “high-watermark.” Private equity fund managers, on the other hand, receive their incentive fees when the fund exceeds the annualized “hurdle rate,” commonly 8%.
There are high risk factors involved in both cases, but their differences in operation will guide you in making the choice that best suits your investment style.
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