Private Equity vs Hedge Fund

Difference Between Private Equity and Hedge Fund

Private equity can be defined as the funds that the investors take into use for the acquisition of public companies or to make an investment in private companies, On the other hand, hedge funds can be defined as privately owned entities that raise funds from the investors and then invest them back into financial instruments bearing complicated portfolios.

A private equity fund is usually taken into use in cases like the acquisition of companies, expansion of an entity, or to strengthen the balance sheet of an entity. In private equity, investors who have shown an interest in funding businesses are offered a prospectus for fundraising. Hedge funds are formed as limited liabilityLimited LiabilityLimited liability refers to that legal structure where the owners' or investors' personal assets are not at stake. Their accountability for business loss or debt doesn't exceed their capital investment in the company. It is applicable in partnership firms and limited liability companies.read more corporations for safeguarding the investors and the managers from the lenders if at all, the funds are bankrupt.

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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 sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more, or to bring new technology in the company to increase output. Institutional investors and accredited investors are a significant 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 a private one.

What is Hedge Fund?

Hedge Fund is just another name for Investment PartnershipInvestment PartnershipAn investment Partnership is a form of business partnership wherein at least 90% of its assets are the investments in intangible assets like bonds, stocks, or options & at least 90% of the income is acquired from that asset type. read more. The meaning of the word ‘hedge’ is protecting oneself from the financial losses; thus, Hedge Funds are designed to do so. Although a risk factor is always involved, it depends on the return. The more the risk, the higher is the return. Hedge Funds are alternative investments done by pooling funds involving several strategies to earn high returns for the investor. Hedge funds are not regulated by the securities and exchange commission and can be used for a range of securities compared to mutual funds. Hedge Funds work on the Long-Short strategies, which means investing in long positionsLong PositionsLong position denotes buying of a stock, currency or commodity in the hope that the future price will get higher from the present price. The security can be bought in the cash market or in the derivative market. The course of action suggests that the investor or the trader is expecting an upward movement of the stock from is prevailing levels.read more, i.e., buying stocks as well as short positionsShort PositionsA short position is a practice where the investors sell stocks that they don't own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date.read more, which means selling stocks with the help of borrowed money and then buying them again when the price is low.

Private Equity vs. Hedge Funds Infographics

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Key Differences Between Private Equity and Hedge Funds

  • Private equity funds are the investment funds that are typically owned by limited partnerships to buy and restructure companies that are not traded publicly on the stock exchangeStock ExchangeStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ.read more. In contrast, hedge funds are privately held, and these pool investors’ funds and then reinvest the same into financial instruments that have a complicated portfolio.
  • Private equity funds invest in companies that can provide higher profits over a more extended period. In contrast, hedge funds are used to invest in assets that yield good ROI or return on investment over a shorter period.
  • Investors in private equity funds have the liberty to invest funds as and when required, whereas, in hedge funds, the investors will need to make investments all in a single go.
  • Private equity funds are closed-ended investment funds, whereas hedge funds are open-ended investment funds.
  • Private equity funds do not have any sort of restriction on transferability over a specified time frame, whereas hedge funds have restrictions on transferability.
  • Private equity funds are less risky in comparison to hedge funds.
  • The investors in private equity funds act as active participants, whereas the investors in hedge funds are vested with the passive status.
  • Funds life is contractually defined in private equity funds, whereas there is zero limitation on funds’ life in the case of hedge funds.
  • Investors in Private equity funds have a higher level of control over operations and asset management, whereas hedge funds have a lower level of control over assets.

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 cannot be marked to the marketMarked To The MarketMarking to market (MTM) is the concept of recording the accounts, i.e., the assets and liabilities at their fair value or at the current market price, which varies with time rather than historical cost. It helps to represent the company's actual financial condition.read more 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. 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, whereas Private equity has a term of 10 to 12 years, which can be extended further by the Manager/GP entity with the consent of all the investors.

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 the near future for any deal done by the portfolio managerPortfolio ManagerA Portfolio Manager is an executive responsible for making investment decisions & handle investment portfolios for fulfilling the client’s investment-related objectives. Also, he/she works towards maximizing the benefits & minimizing the potential risks for clients. read more 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 securitiesMarketable SecuritiesMarketable securities are liquid assets that can be converted into cash quickly and are classified as current assets on a company's balance sheet. Commercial Paper, Treasury notes, and other money market instruments are included in it.read more which are traded in real-time.

Performance Measurement and Realization

The performance of Private equity is measured in terms of Internal Rate of Return (IRR), and usually, a minimum hurdle rateHurdle RateThe hurdle rate in capital budgeting is the minimum acceptable rate of return (MARR) on any project or investment required by the manager or investor. It is also known as the company’s required rate of return or target rate.read more 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 the early years. The performance of Hedge funds are realized continuously while the investment of assets.

Allocations and Distributions

Some significant 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 liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order.read more 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.

Fee Comparison

Fees of Private Equity are evaluated on several 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 fundHedge FundA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques.read more is a 1.5% fee for management and a 20% fee based on performance. Hedge fund usually earns performance fees on the first dollar of profit. In contrast, performance fees in Private equity are 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 exist to make money out of the investments, and a high-risk factor is involved in both the funding options. It is crucial to assess the differences between the two and choose accordingly.

Comparative Table

Basis of comparisonPrivate Equity FundsHedge Funds
DefinitionPrivate equity funds are the funds that are used by the investors for making an investment in private entities or acquisition of entities that are publically enlisted on the stock exchange.Hedge funds are all about the private limited companies raising funds from the investors and then reinvesting them back into financial instruments that have a risky portfolio.
Time frame with respect to investmentPrivate equity funds is all about making an investment in companies that are capable enough of offering substantial returns over a longer period of time. In other words, private equity funds invest in portfolios that can yield returns over a longer period.Hedge funds focus on making an investment in companies that are capable of offering substantial profits on ROI (return on investment) in the nearing time. In other words, hedge funds seek to make an investment in portfolios that can yield return within a shorter period of time.
Restrictions of transferabilityPrivate equity funds are closed-endedFunds Are Closed-endedA closed-end fund refers to a professionally managed fund whereby an investment company issues the initial public offering to raise capital. Later, these stocks are exchanged in the open market among the shareholders like other shares. Such investments provide better returns than the open-end funds.read more investment funds that have restrictions with respect to transferability. However, these restrictions are applicable only for a particular period of time.Hedge funds are open-ended investment funds that do not really have any sort of restriction on transferability.
Capital investmentThe investors opting for private equity funds will need to invest the capital as and whenever called upon.The investors opting for hedge funds will need to make a one-time investment only.
Level of risksPrivate equity funds are less risky as compared to hedge funds.Hedge funds carry higher levels of risks since these emphasize more on deriving huge returns and that too within a shorter period of time.
TaxesThe gains earned in private equity funds are not subjected to tax rates.The gains earned in hedge funds are subjected to taxes.
Level of control over assetsPrivate equity funds have a greater level of control and influence over asset managementAsset ManagementAsset management is a method of managing funds and investing in both traditional and specialized products in order to generate returns consistent with the investor's risk tolerance. read more and operations. The investors of a private equity fund can actively participate in changing business strategies, implementation of governance, and initiating operational improvements.Hedge funds have a lesser level of control over assets, and these also do not have any voting powers. It is because of the fact that hedge funds are usually minority investors that have little or zero control over the investments.
TermIn private equity, funds’ life is contractually defined.In hedge funds, there is zero limitation on funds’ life.
Stakes heldSmall stakes in companies that are publically listed on the stock exchange;Significant stakes in companies that are closely held;
Management fees1 to 2 percent of assets that are actively managed;1 to 2 percent of the assets that are under management;
Investment horizonThese are usually long term.Hedge funds are generally short term.
Level of participationThe investors are active participants in a private equity fund.The investors are vested with the passive status in a hedge fund.

Conclusion

Private equity funds, as the name implies, is all about making an investment in private companies through direct investments or funds, whereas, in hedge funds, investors can choose to invest and trade in different types of financial securities and markets through leveraging or short selling. The level of risks in hedge funds is way higher as compared to private equity funds. The gains earned from the private equity funds are exempted from tax, whereas the gains earned from the hedge funds are adjusted for taxes.

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Comments

  1. Priyank says

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    • Dheeraj Vaidya says

      Thanks for your kind words!

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  4. neeraj says

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    • Dheeraj Vaidya says

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