What is a hedge fund?
A hedge fund is an alternative investment that pools money from investors to generate returns, often through unconventional, aggressive, or advanced trading tactics.
They’re high risk and not highly regulated, and investors must be accredited.
What is private equity?
Private equity (PE) is an investment strategy where money is pooled from a group of investors and invested in private companies to generate returns.
Private equity companies use various strategies to generate returns, including leveraged buyouts, growth equity, venture capital, private credit, and secondary investments.
What are the differences between hedge funds and private equity?
Hedge funds and private equity differ in many ways, including time horizon, liquidity, strategy, and ownership. Let’s take a deeper look:
| Hedge fund | Private equity | |
|---|---|---|
| Investment horizon | Mid-term, initial lock-up period of one year. | Long, seven to 10 years. |
| Liquidity | Shares in the hedge fund can be redeemed either once per month or once per quarter after the initial lock-up period. | Highly illiquid, may have a contractual initial life of 10 years. |
| Strategy | Varied, often involve complex trading strategies to generate returns that outperform the market. | Leveraged buyout, venture capital, growth equity |
| Ownership/Structural | Investors buy shares in a hedge fund. | Investors become limited partners (LPs). |
Investment horizon
Private equity investments have a much longer horizon, often 10 years or more. Hedge funds have a much shorter investment horizon; however, they do have an initial lock-up period of around 12 months.
Liquidity
Redemptions for hedge fund shares are limited to either once per month or once per quarter. There’s an initial lock-up period of around 12 months before shares can be redeemed. Private equity investments are long-term, often lasting 7 to 10 years or more.
Strategy
Hedge funds and private equity firms pursue different strategies for generating returns, but both offer exposure to unique investments and may offer more diversification to your portfolio. Hedge funds may look to complex trading strategies based on quantitative models, credit, currencies, commodities, and more. Private equity firms often seek growth by taking a controlling interest in a company, improving operations, and directing the company in order to increase its value.
Ownership
Private equity typically operates as a partnership with the general partner (GP) managing day-to-day decisions while the limited partner provides the capital. Hedge funds offer investment in shares.
What are the similarities between hedge funds and private equity?
Hedge funds and private equity firms share some similarities, such as:
| Hedge fund | Private equity | |
|---|---|---|
| Investor eligibility | Only open to accredited investors or qualified clients | Only open to accredited investors or qualified clients |
| Goal | Outperform traditional markets | Outperform traditional markets |
| Structure | General partner and limited partner | General partner and limited partner |
| Risk profile | High risk | High risk |
| Fees | Management + performance fees | Management + performance fees |
| Asset types | Private investment | Private investment |
Investor eligibility
Not all investors are eligible to invest in hedge funds and private equity investments. Generally, investors must be considered either accredited investors or qualified clients. Investors may need at least $100,000 for these types of investments.
Goals
Both hedge funds and private equity have the goal of generating outsized profits above what the typical market return offers.
Structure
Private equity and hedge funds are often structured with general partners and limited partners. General partners oversee operations and make day-to-day investment decisions while limited partners provide the capital.
Risk profile
Both hedge funds and private equity are considered risky investments. There’s less transparency and more complex strategies involved with these two types of investments.
Fees
Both hedge funds and private equity funds charge fees for the management and performance of the investment. Management fees are approximately 1-2% of the fund's net asset value each year. Performance fees between 10% and 20% of profits are charged each year.
Asset types
Both hedge funds and private equity represent investments in the private sector. These investments aren’t highly regulated and aren’t available to most investors. Certain requirements must be met to become an investor.
What are the pros and cons of hedge funds and private equity?
Hedge funds and private equity investments each come with pros and cons to consider.
Hedge funds pros and cons
Pros
More flexibility: Hedge funds have flexibility in pursuing returns, including complex trading positions, diverse asset classes, event-driven trades, credit investing, and more.
Higher returns: Hedge funds may deliver high returns, but they can also underperform the market.
Diversification: Hedge funds offer diversification through exposure to alternative investments and strategies.
Cons
High fees: Hedge funds charge high fees. You may pay a management fee of 2% of the net asset value (NAV) plus 20% of profits.
Higher risk: Hedge fund positions take on risk, especially with leverage. You could lose your entire investment.
Less transparency and regulation: Hedge funds are not registered investments, so there’s no protection against conflicts of interest, no requirement to redeem daily, no requirement to disclose holdings, may not be priced fairly, and lack leverage limits.
Accessibility: Only accredited investors can invest with hedge funds.
Illiquid: Hedge funds limit redemptions. Depending on the hedge fund, it may be limited to monthly, quarterly, or fewer opportunities to redeem shares each year. They can also suspend redemptions during turbulent markets.
The pros and cons of private equity
Pros
Potential for high returns: Private equity can deliver strong returns for investors. Average returns exceed 11%.
Broad range of investment opportunities: Private equity offers opportunities not available on the public markets.
Diversification: Private equity provides diversification in your portfolio because it’s not correlated to public markets.
Cons
Illiquid investment: Your money is tied up in the investment for years.
Long-term horizon: Expect your money to be tied up for 10 years or more.
Cost: Fees for private equity investments are higher than for other types of investments. GPs are paid a share of profits in addition to a management fee.
Limited transparency: You give control of the investment over to a manager and won’t know the details of how your money is being used.
Company-specific failures: Factors outside your control may cause companies in the portfolio to fail.
Do hedge funds invest in private equity?
Yes, hedge funds can invest in private equity.
Hedge funds may start their own private equity funds or invest in private companies like a private equity firm would. There is overlap in the type of investments hedge funds can make in the private sector.
Is a hedge fund private equity?
A hedge fund is not private equity, though hedge funds can start private equity branches and employ some of the same strategies.
Hedge funds and private equity firms are distinct entities with differing investment strategies.
Hedge funds have a great deal of flexibility and typically focus on publicly traded investment vehicles, while private equity invests in private companies over a longer horizon.
The bottom line
There’s no substitute for expert financial advice, especially if you’re looking at hedge funds and private equity investing. You need an advisor who knows the industry and can help you build a portfolio that meets your needs.
Get matched with an advisor through Unbiased today for all your investing and retirement questions.