Private Equity vs Hedge Fund

Publication Date :

02 Jul, 2016

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Table Of Contents

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 used in cases like the acquisition of companies, expansion of an entity, or strengthening the balance sheet of an entity. In private equity, investors interested in funding businesses are offered a prospectus for fundraising. Hedge funds are formed as limited liability corporations for safeguarding the investors and the managers from the lenders if the funds are bankrupt.

Difference Between Private Equity and Hedge Fund

What is Private Equity?

Private equity is the investment capital invested by any high net worth individual in a firm to acquire equity ownership in the firm. These capitals are not quoted on a public exchange. The capital can be used to expand the company's working capital, strengthen the balance sheet, or bring new technology into the company to increase output. Institutional investors and accredited investors are a significant part of the private equity in any company because they can 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 Partnership. The word 'hedge' means protecting oneself from financial losses; thus, Hedge Funds are designed. 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 positions, i.e., buying stocks and short positions, 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

Private-Equity-vs-Hedge-Fund-info-updated

Key Differences Between Private Equity and Hedge Funds

Private equity funds are the investment funds typically owned by limited partnerships to buy and restructure companies that are not traded publicly on the stock exchange. In contrast, hedge funds are privately held, and these pool investors' funds and then reinvest the same into financial instruments with 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 restrict 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.
Fund 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 investments that cannot be marked to the market and have restrictions on transferability. At the same time, Hedge Funds exist in traditional open-end investment funds, which are generally suitable for investment vehicles with an established trading market. In addition, there are no restrictions regarding 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 the 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 shortly 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 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 rate applies to Private Equity. While in Hedge funds, returns are immediate, and sometimes, performance is measured according to a benchmark for gaining more incentive fees.

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. On the other hand, the performance of Hedge funds is 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. For example, in private equity, the 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 the investor's contributed amount, which is further distributed among investors and fund manager, generally, in the ratio of 80-20. On the other hand, a hedge fund investor never recovers the amount invested until the fund is terminated for some reason or deliberately withdraws from the funds.

Fee Comparison

Fees of Private Equity are evaluated on several assumptions: investment period, fund life, average holding period, carry percentage, and maximum percentage funded. Private equity fees are two-tiered. Tier 1 is 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 a 1.5% fee for management and a 20% fee based on performance. Hedge funds usually earn performance fees on the first dollar of profit. In contrast, performance fees in Private equity are not earned until the investor achieves the target of preferred return. Preferred return in Private Equity is the reason behind the lower fees.

Both exist to make money from the investments, and a high-risk factor is involved in both the funding options. Therefore, it is crucial to assess the differences and choose accordingly.

Comparative Table

Basis of comparison	Private Equity Funds	Hedge Funds
Definition	Private 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 listed 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 investment	Private equity funds are 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 near future. In other words, hedge funds seek to make an investment in portfolios that can yield return within a shorter period of time.
Restrictions of transferability	Private equity funds are closed-ended 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 investment	The 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 risks	Private 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.
Taxes	The 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 assets	Private equity funds have a greater level of control and influence over asset management 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.
Term	In private equity, funds’ life is contractually defined.	In hedge funds, there is zero limitation on funds’ life.
Stakes held	Small stakes in companies that are publically listed on the stock exchange;	Significant stakes in companies that are closely held;
Management fees	1 to 2 percent of assets that are actively managed;	1 to 2 percent of the assets that are under management;
Investment horizon	These are usually long term.	Hedge funds are generally short term.
Level of participation	The investors are active participants in a private equity fund.	The investors are vested with the passive status in a hedge fund.

Conclusion

As the name implies, private equity funds are all about investing in private companies through direct investments or funds. 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 than in 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.