Private equity funds invest capital into a public or private firm to acquire a controlling stake in that firm. This money can be put to use in numerous ways, such as the strengthening of a balance sheet or the acquisition of new technology to increase output. Otherwise, private equity may simply be used to expand working capital.
A hedge fund is another name for an investment partnership that is created to protect investors from financial losses. They are an alternative form of investment where funds are pooled and used in several different strategies to earn returns for each investor.
One of these is the so-called “long-short” strategy, where the hedge fund takes a long position in some stocks and a short position in others.
Key differences between private equity funds and hedge funds
With the above in mind, let’s explain some of the key differences between private equity and hedge funds.
Hedge fund managers tend to be on the lookout for assets that can deliver a worthwhile ROI in a short time frame. In other words, they prefer liquid assets that enable them to quickly move from one investment to the next.
Conversely, private equity funds take more of a long-term view with respect to the profit potential of a company. They are not interested in running a business or acquiring one that needs to be turned around.
Instead, they usually take a controlling stake with a leveraged buyout (LBO) and then make improvements to the company’s management or operations. On average, this investment horizon is around 5 to 7 years.
Members of a private equity fund chose how much capital they are willing to invest and only have to do so when called upon. However, financial penalties can result if the investor does not honor the capital call of the fund manager.
Members of a hedge fund invest all their money at once and, unlike the private equity investor, are not required to commit their money for a predetermined period.
Compensation and fee structure
There are also differences in the ways both funds are compensated. Typical private equity fund managers will charge a 1-2% management fee on top of a 20% incentive or profit-sharing fee.
Hedge fund managers may also collect similar fees while others base them on the net asset value (NAV) for each investor and the high water mark.
This number depends on the timing of an individual investment compared to the year-over-year (YOY) rise and fall of the fund.
Instead of the high watermark, private equity funds use the hurdle rate and managers only earn an incentive fee once this mark has been reached.
For example, if the hurdle rate is set at 7% and the annualized returns reach 6%, no fee is charged.
Hedge fund investments are inherently riskier because of their preference to maximize profits in a shorter period of time.
Having said that, both hedge funds and private equity funds combine riskier investments with those deemed safer as part of their risk management strategies.
- Private equity funds invest capital into a public or private firm to acquire a controlling stake in that firm. A hedge fund is an investment partnership created to protect investors from financial losses where funds are invested into long and short positions.
- Hedge fund managers are more interested in assets that can deliver a worthwhile ROI in a short time frame. Private equity managers take a longer-term view as they acquire a controlling stake in a company and then improve it to ideally sell for a profit after many years have elapsed.
- Hedge funds and private funds also differ in the way investment capital is handled. Generally speaking, there are also key discrepancies in terms of risk management and compensation or fee structure.