Private equity versus hedge fund – How are they different?
Private equity and hedge funds might come across as having the same meaning. However, the way these two entities function is greatly different. Even the investing methodology and the returns are different compared to how a private equity and a hedge fund function.
Most investors prefer to own stocks or bonds or other variations such as mutual funds to diversify their portfolio. Both private equity and hedge funds fall into the alternative investment fund category. Due to the fact that both these types of investments require large capital, the risks are higher compared to traditional investing vehicles.
In this article, we aim to explain the differences between private equity and hedge funds and how these two aim to manage and invest money. Both private equity and hedge funds cater to the high net worth individuals. This puts both these out of reach from the average investor.
There is also a more structured approach involved for these types of investments.
At the very high level, both private equity and hedge funds focus primarily on the stock markets. Both aim to build returns for the investor. But that is where the similarities end.
What is Private Equity?
Private equity, in its most simplest of explanation is just the capital or shares of combined ownership that are not publicly available for trading and neither are they listed like stocks.
As the name suggests, for this reason the private equity is established through the private equity firms and is often seen as an investment or in a buy out of a public company which is taken private.
Investors typically raise capital when creating private equity, which are then pooled together. Investors raise capital to invest in the private companies which are for either facilitating the mergers and acquisitions of the company’s balance sheet or to raise new working capital.
The capital is often contributed by institutional investors which becomes a part of the private equity. The bottom line with private equity being that investors get a return on their investment.
Private equity firms undertake many corporate actions which includes buying out of financially struggling companies and turning them around by involving management and restructuring.
Private equity firms can also directly invest in a company and help in facilitating the mergers and acquisitions or even in the initial public offerings and exit when a healthy return on the investment is realized.
What do private equity firms invest in?
Examples of some of the biggest private equity firms include names such as Apollo Global Management LLC. This firm alone has $15 billion in total assets under management. Another major player in the private equity business in Blackstone Group.
There are many types of institutions that also invest in private equity firms. These include pension funds and other investment firms. The main purpose for these firms is to invest in the private equity with hopes that the private equity firm’s ventures will make the right investment decisions and make a profit on their investment.
One reason why individual firms choose the path of investing in a private equity is that it usually requires a larger amount of capital that is out of reach for the average investment firm. As a result, multiple firms invest with capital in the private equity firms which then have enough capital to raise money.
Privat equity firms are often wealthy and hold a strong influence in the industry. They also hold sway on any major operations of most private or public companies at some point.
The duration of time that private equity firms hold the investment can be for extremely long periods of time. During this period, the private equity firms use the capital for a number of reasons including improving operations of the company or to increase the liquidity in order to prepare the firm for its initial public offering.
For example, Bain Capital is one such private equity firm which has considerable stakes in publicly traded firms such as Burger King, Staples and many more big names.
Investors in private equity often extend funds over a long holding period, during which the company's new found capital is used to improve operations and profits or to increase liquidity in preparation for an IPO.
For companies that are private, using the resources of a private equity firm is beneficial. This is because these companies do not have to file quarterly earnings report and hence, they can focus on long term projects that actually increase the company’s value and earnings. The much needed capital injection from the private equity firms is certainly a blessing in this case.
Leveraged buyout is a term that is used exclusively when it comes to private equity investment. Leveraged buyout is where firms invest into a private equity fund to raise the required capital which will help them to entail the use of the excess funds to buy out a company and fund its various activities.
What is a hedge fund?
A hedge fund is a type of investment fund that is only suitable for sophisticated investors. Typically, these sophisticated investors are institutions and individuals who have significant assets.
Hedge funds, as the name suggests are pools of underlying securities and behave in a somewhat similar way to mutual funds.
Hedge funds can invest in many types of securities. What is unique about hedge funds is that they are not regulated by the Securities and Exchange Commission or similar financial watchdog. This makes hedge funds, somewhat different from mutual funds.
The term hedge means that the hedge fund manager hedges their risk and aims to generate a risk neutral portfolio. However, this is not the case all the time. Hedging can be done in many ways based on the markets that are being traded.
Due to the lack of regulation, hedge funds can invest in a number of wider assets besides just traditional securities.
This is the drawback with mutual funds for example which are highly regulated and require investments only in traditional securities. Hedge funds are known for making money regardless of the market direction. Therefore, hedge funds can make use of a long short strategy as well.
In this scenario, hedge funds can invest in a stock and also borrow stocks to short it, thus making a profit in either directions. Hedge funds can also make use of the derivatives market in order to make their profits.
Hedge funds are usually benchmarked by the performance of the equity indexes such as the S&P500. It is often said that only a few hedge funds are able to generate market beating returns on a consistent basis.
What do hedge funds invest in?
A hedge fund invests in different markets depending on the type of strategy that they pursue. Overall, a hedge fund can focus on a long and or short strategy, meaning that they can buy as well as short sell the equity markets.
Hedge funds are aimed to make profit for the investors regardless of the direction. Therefore, hedge funds also invest in bonds and derivatives to achieve this goal.
While a hedge fund works similar to a mutual fund, the regulatory oversight is less compared to the latter. Also, hedge funds are accessible to only accredited investors. Some hedge funds can also invest in real estate and currencies.
Hedge funds are set up as limited partnerships and require a large amount of investment which is usually higher than the market standards.
By definition, hedge funds are expected to outperform the standard benchmark indexes. Therefore, hedge funds are usually risky. By some statistics, hedge funds do not perform as expected, meaning that they do not consistently beat the market indexes.
The performance of the hedge funds are measured by the returns that they generate and includes various performance measures such as World government bond index and rate of return.
Some of the most popular hedge funds are names such as Blackrock investments, managed by the famous Ray Dalio. Blackrock has total assets under management to the score of $4.32 trillion.
Difference between a hedge fund and private equity?
Now that we have an understanding of how a hedge fund and a private equity works, let’s take a look at what are the differences between these two.
Private equity funds operate in a similar fashion to a venture capital. They invest in private companies in order to build the company for a public offering. Sometimes, private equity funds also invest in startups.
Hedge funds aim to provide the investor the highest return within a shortest period of time, regardless of the direction in the markets (bullish or bearish markets)
The duration of returns one can expect from a private equity can span over a few years and sometimes even a decade.
Hedge funds are short term, and therefore, the performance is usually measured on an annual basis.
Private equity firms only invest in companies that are either private or already public. They have a close relationship with the management. The investment also involves actively managing the company’s leadership and influences the direction of the company.
Hedge funds invest in highly liquid assets and can diversify their portfolio between equity and debt. Due to the fact that hedge funds need to make money regardless of the market direction, hedge funds also actively trade the derivatives market.
Not everyone can invest in a private equity firm because the capital requirements are quite high. Moreover, private equity firms are structured as a partnership where each of the partners get a share for the amount of money invested.
Hedge funds are comparatively easier to invest in, but still large capital is required. Typically, the fund manager manages the money and there is a management fee and other expenses involved.
Private equity versus hedge fund – What’s best for you?
Before we begin to even answer this question it is important to know that both private equity and hedge funds are available only for accredited or institutional investors. As a result, these two alternative types of investment methods require high capital.
Secondly, there are some aspects to bear in mind such as the structure of the company. Private equity and hedge funds are set up as companies, but the structure can vary. Private equity also focuses on a different form of investment.
Here, the firm targets the longer term horizon. Therefore, private equities require a long holding time. This can vary from a few years to half a decade. The returns are usually big because private equity focuses very closely on the company’s operations.
Some private equity ventures can be profitable especially if they are able to successfully take a private company to a publicly listed company.
Hedge funds focus on the companies that are already listed.
However, their strategy is defined by their mandate. Therefore, it is not uncommon to see that hedge funds can at times also invest in a private company.
Hedge funds are usually a bit riskier as they are expected to generate returns for their investors. As a result, hedge funds can invest in the traditional stock markets and move into other forms of investing such as private companies, bonds, derivatives, retail estate and currencies.
In order to choose which of these two types is more suited for you, it depends on firstly the amount of money you want to invest. As an institutional investor, the next aspect to focus is the tenure of the investment.
Private equity investment usually requires closer scrutiny of the company where the firm invests in. This can be a bit tedious compared to traditional forms of investing where you simply buy a stock based on the fundamentals.
It is the same with a hedge fund as well. Investor simply pool in their funds and it is the responsibility of the fund manager to generate the expected returns. Therefore, in a way, hedge funds are a bit easier to handle as you do not need to be involved in the day to day activities and decision making for the companies you invest in.