Difference Between Hedge Fund and Private Equity

With the ever growing opportunities of making money in the financial market, investors have been introduced to a large number of instruments, such as bonds, stocks, mutual funds, forward contracts, futures, and more. However, in order to further diversify away from the risk and strengthen the portfolio, investors can also go for hedge funds and private equity funds. These funds are sold in the market via private offerings that place their reliance on exemptions from registration. The investors’ funds are tied up in such investments longer than other securities, like stocks or exchange traded funds, with an intention to make better profits. Although, both the investment opportunities are often talked about in the same breath and fall under the alternative investment category, yet, there are a number of differences between the two.

Hedge Funds

Hedge funds and investment partnerships are one and the same thing. The word “hedge” means protecting oneself from the financial losses, and this is exactly why these funds have been designed. The investment is done by pooling funds, whereby, a number of strategies are employed to make high profits for investors.

The purpose of hedge funds is to make profits on investment as soon as possible. To make that happen, the investments are initially made in highly liquid financial assets so as to generate returns quickly on one investment and then move the money into another investment that is rather promising. Unlike mutual funds, it can be used for a variety of financial securities. The hedge funds can invest in a variety of instruments, including arbitrage, bonds, stocks, derivatives, futures, commodities, and any security with a potential to make high profits in a short period of time.

Private Equity

Private equity, on the other hand, is a capital amount invested by wealthy individuals with a purpose of gaining equity ownership in a business. These funds can be used to fulfill working capital requirements of a business in order to improve a balance sheet or can be used to make a material investment for smooth running of operations in an effective manner. The main contributors in private equity are accredited investors and institutional investors, as they can afford to keep their funds invested for a longer period of time.

Private equity funds are like venture capital investment, whereby, they invest in businesses and properties with an aim to manage, grow and eventually sell the assets. It usually takes about three to five years for an investment to become fully realized. Private equity is also used to convert the public company into a private domain, where business is under less scrutiny from public investors.

Differences

It is important for an investor to be aware of the differences in order to make sound investment decisions, keeping in mind their structure, terms, liquidity condition, performance, taxes, risks, etc.

Structural Difference

The first difference between these two types of investments is that they are structurally different. Private equity is a close ended investment fund, as its current market price cannot be easily determined and cannot be transferred for a certain period of time. Whereas, hedge funds fall under the category of open-ended investment fund where there is no restriction on the transferability of funds and assets are readily marked-to-market.

Terms of the Fund

The term of private equity funds varies between ten to twelve years based on certain criteria. The period can be extended by a fund manager after getting the consent of all the investors. On the other hand, hedge funds do not have any specific term.

When to Invest?

The investor doesn’t have to invest immediately into private equity. Instead, he can submit his commitment to invest in the future for any deal finalized by a portfolio manager in the private market. There is no defined period of time as to when the money can be called.

In case of hedge funds, investors have to invest the money immediately, which goes straight into the marketable securities that are traded in real time.

Strategy

Hedge funds are managed and operated by market traders, who are investment professionals. They move in and out of financial instruments and look for the best possible returns. Hedge fund managers tend to go for high risk in order to generate a high level of profits.

Private equity funds are invested by either purchasing an entire business or acquiring selected assets. These businesses are mostly underperformed and private equity firms purchase them in order to improve its performance by using their own professional expertise.

Short-term Gain Vs. Long-term Gain

As already discussed, hedge funds are focused toward earning short term gains. But this isn’t the case with private equity funds, as they keep their focus on long term prospects of the portfolio of businesses they invest in or acquire. Once they can exercise substantial control over a company, they can make changes in the company’s management, streamline operations, and can sell a company at profit, privately or through an IPO (Initial Public Offering) in a stock market.

Risk Level

There is a significant difference between in risk level of hedge funds and private equity funds. Although, both the funds undertake risk management by investing in high-risk investments as well as low-risk safer investments, yet, hedge funds tend to achieve short term profits, eventually leading to taking higher risk.

Performance Measurement

The performance of Private Equity funds can be measured by calculating the internal rate of return (IRR), wherein, a minimum hurdle rate is applied to the equity. Whereas, the profits from hedge funds are immediate and in order to gain incentive fee, the benchmark is used for performance measurement.

Allocation and Distribution of Funds

Another main difference between these funds is the allocation and distribution of funds between the managers and investors. Investors can never recover the investment money from hedge funds until the funds are terminated for some reason or if they choose to withdraw. In case of private equity, money generated from portfolio liquidation is distributed until investors receive the entire amount they initially invest. They also receive preferred returns sometimes, which represents a percentage of the investors’ contributed amount.

Liquidity

Liquidity shows the ability of asset manager to generate cash. Although, both the investments are considered less liquid as compared to other investment vehicles, hedge funds are still more liquid than private equity as per the findings of the Advisory Council on Employee Welfare and Pension Benefit Plan, which was published on the website of the U.S. Department of Labor. Moreover, the value of an asset in private equity portfolio is not easy to determine as compared to a hedge fund due to the nature of the assets held by them.

Taxes

There is a form called K-1 generated by hedge funds and private equity funds, in which, taxable profits, revenue, and losses of the investors are reported. In case of hedge funds, a part of short term vs. long term profits is based on how frequently the portfolio manager gets hold of the investment assets. Bonds and other revenue making financial securities held by hedge funds may give rise to the ordinary income tax.

As for private equity, most of the holdings stay in the portfolio of assets for a period of more than twelve months. Therefore, they are considered capital gains on which tax is levied.

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