Private Equity vs Hedge Fund – Most of the individuals prefer stocks, bonds, and mutual funds for investing their money but if you are an investor and want to diversify your portfolio and venture into alternative investments then Hedge Funds and Private Equity funds are for you. A large amount of risk is involved in the both types of funding but therein lies a significant difference between the two. Here, we will try to point out some major differences between Private Equity and Hedge Funds.
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#1 – Conceptual Differences
What is Private Equity?
Private equity is the investment capital invested by any high net worth individual in a firm with the aim of acquiring equity ownership in the firm. These capitals are not quoted on a public exchange. The capital can be used for expanding the working capital of the company, to strengthen the balance sheet or to bring new technology in the company to increase output. Institutional investors and accredited investors are the major part of the private equity in any company because they have the ability to commit a large sum of money for a longer duration of time. Often, private equity is used to convert a public company into private one.
What is Hedge Fund?
Hedge Fund is just another name for Investment Partnership. The meaning of the word ‘hedge’ is protecting oneself from the financial loses thus Hedge Funds are designed to do so. Although a risk factor is always involved but it depends on the return. More the risk, higher is the return. Hedge Funds are alternative investments done by pooling funds involving a number of strategies to earn high returns for the investor. Hedge funds are not regulated by Securities and Exchange Commission and can be used for a range of securities as compared to mutual funds. Hedge Funds work on the Long-Short strategies which mean investing in long positions i.e. buying stocks as well as short positions which mean selling stocks with the help of borrowed money and then buying them again when the price is low.
#2 – Private Equity vs Hedge Fund – Structural Difference
Private equity comes under the category of closed end investment funds which are generally suitable for the investments which are cannot be marked to the market and have restrictions on transferability for a duration of time while Hedge Fund exists in the category of traditional open end investment funds which are generally suitable for the investment vehicles which have an established trading market and there are no restrictions regarding the transferability, that is, assets are available to be marked to market readily. When speaking of the term, hedge funds do not have any specific term where as Private equity has a term of 10 to 12 years which can be extended further by Manager/GP entity with the consent of all the investors.
#3 – When do you have to release money?
In the case of Private equity, you don’t have to invest money immediately from your account instead you have to commit the capital to be paid in near future for any deal done by the portfolio manager in the private market. There is no fixed time duration as to when your money can be called whereas in the case of Hedge funds, you have to release the committed amount immediately from your savings. This amount is invested in the marketable securities which are traded in real time.
#4 – Performance Measurement and Performance Realization
The performance of Private equity is measured in the terms of Internal Rate of Return (IRR) and usually a minimum hurdle rate is applicable to Private Equity. While in Hedge funds returns are immediate and sometimes for gaining more incentive fees performance is measured according to a benchmark.
Performance realization for Private equity is generally after the hurdle rate has been achieved and mostly negative performance is reported by Private Equity during early years. The performance of Hedge funds is realized continuously while the investment of assets.
#5 – Allocations and Distributions
Some major differences exist between Private Equity and hedge funds in terms of the allocation and distribution of the fund between investors and fund managers. In private equity, distribution of portfolio liquidation carries on until the investor has received the amount he invested and sometimes “preferred returns” are also received which are calculated as some percentage of investor’s contributed amount which is further distributed among investors and fund manager, generally, in the ratio of 80-20. A hedge fund investor never recovers the amount invested until the fund is terminated due to some reasons or he deliberately withdraws from the funds.
#6 – Private Equity vs Hedge Fund – Fee comparison
Fees of Private Equity is evaluated on a number of assumptions such as investment period, fund life, average holding period, carry percentage and maximum percentage funded. Private equity fees are two tiered. Tier 1 is of the annual fee of 1.5% on committed investment during the first five years and then 1.0 % after five years. The most common fee structure for the Hedge fund is 1.5% fee for management and 20% fee on the basis of performance. Hedge fund usually earns performance fees on the first dollar of profit while performance fees in Private equity is not earned until the target of preferred return is achieved by the investor. Preferred return in Private Equity is the reason behind the lower fees.
Both Private Equity and Hedge Fund exist to make money out of the investments and a high risk factor is involved in both the funding options. It is important to assess the differences between the two and choose accordingly.