Hedge funds and private equity are two types of investment funds, but with very different strategies. Both offer a very different approach to making money, so it’s essential to know the difference between them if you’re considering putting your hard earned money in one of these vehicles.
What is Private Equity?
Private equity involves buying a stake in a company that has not gone public and therefore is not traded on the open market. There are fewer regulations related to operations and finances, as well as other limitations for investors. Private equity firms often provide companies they invest in with additional capital and resources that may be difficult or expensive for them to get through traditional funding sources. Unlike publicly-traded equities, investors are often subjected to a lock period on their investment, meaning they can’t sell for a specified amount of time.
Private equity firms often engage in buy out activity, which means they use their funds to purchase majority shares of a company, giving them complete control over operations. They are interested in acquiring companies that either need restructuring or have excellent growth potential.
What is a Hedge Fund?
Hedge Funds are investment pools that add a unique form of risk management to the financial sector.
This is accomplished through leveraging techniques and utilizing high-risk instruments with low-risk supplements. Hedge funds sometimes use hedging strategies to protect against risks, such as fluctuating securities or currency market prices. These funds can also be utilized in many different ways and serve numerous purposes compared to more regulated mutual funds, which makes them very effective at maximizing profits if managed well.
Private Equity vs. Hedge Fund
Private equity and hedge funds have some similarities. Both allow investors to pool their money and invest it in various assets such as stocks, bonds, and real estate. However, there are also some critical differences. Below is a comparison of these two investments:
Investment Time Horizon
Private equity firms generally have a longer investment horizon than hedge funds. The typical private equity fund lasts as long as ten years and invests in companies looking to expand their businesses or seeking to take a company public. Hedge funds invest in various assets, including stocks, bonds, currencies, and commodities. However, they typically focus on shorter-term trades.
Capital Investment
Private equity firms raise capital from large institutional investors such as pension funds and insurance companies, who are looking for long-term returns that match the time horizon of their investments. Hedge funds can accept money from individuals as well as institutions. Their investment strategies tend to be more speculative than those of private equity funds because they sometimes use high levels of leverage (borrowing) to increase potential returns for investors.
Legal Structure
Private equity firms tend to be partnerships or limited liability companies (LLCs), and hedge funds are generally structured as corporations or limited partnerships. While both types of investment vehicles have limited liability protection, hedge fund managers have more flexibility in their investment strategies than private equity fund managers. For example, a hedge fund manager can invest in many asset classes. In contrast, a private equity fund manager must limit his investments to sectors like real estate, venture capital, and debt securities.
Fee Structure and Compensation
Hedge fund managers typically take around a 2% management fee on the amount invested in their funds and as much as 20% of any gains over time. Private equity fund managers charge an annual management fee ranging from 1% to 2%; they also receive 20% of the profits generated by the fund after its investors have been paid back with interest and capital gains distributions.
Level of Risk
Hedge funds can be hazardous and can involve leverage, short selling, derivatives, and other sophisticated investment strategies used to generate potential outsized returns. Hedge funds are also not subject to regulations that apply to mutual funds or other investment vehicles.
Private equity, by contrast, may be much less risky. Private equity firms typically invest in public companies that are just starting or struggling firms. They frequently buy these companies because they think they can improve their performance through better management or other changes in strategy.
Taxes
Private equity funds are taxed at the capital gains rate, while hedge funds are taxed as ordinary income, making it potentially more costly to run a hedge fund operation than a private equity one.
Hedge Funds and Private Equity Main Takeaway
When considering the differences between hedge funds and private equity, it is essential to note that a few significant factors are worth mentioning. These financial instruments can help investors achieve returns by providing them with investment strategies that take advantage of market opportunities and potential profits. However, the key differences between hedge funds and private equity firms will determine which, if either, is an appropriate way to put your money to work.
