Hedge funds and private equity funds are both extremely popular investment vehicles, especially among high-net-worth individuals, and both types of funds frequently make the news.

That said, many people are not clear on the significant distinctions between private equity and hedge funds and how those differences affect fund structure, investments, and returns. Here is a basic overview of the differences between a hedge fund vs. a private equity fund.

What Is a Private Equity Fund?

A private equity fund is a means for investors to buy equity and securities that are not available for public trading. A private equity fund typically commits a large amount of money for a long period of time in exchange for equity ownership of a firm. These funds are often used to bring a startup to an IPO or to convert a public company into a private one. Private equity funds typically earn better returns than stocks.

Types of Private Equity Investments

Private equity funds generally fall into the following types:

• Leveraged Buyout (LBO). An LBO either buys a company outright, or purchases a majority stake, combining lenders’ and investors’ money in order to secure large loans and make bigger deals. Some private equity funds specialize in investing in companies in financial crisis, taking control of the business and turning it around, with an aim to make it profitable or sell it at a profit.
• Venture Capital (VC). VC funds provide financing to early-stage startups and new businesses, with the goal of supporting the venture to profitability, and hopefully have an exit through an acquisition or an IPO. The fund generally takes a minority stake in the business, but often offers technical, managerial, or strategic guidance. Growth equity funds are similar to VC, but invest in more mature companies with less speculative returns.
• Real Estate Private Equity (REPE). REPE funds use different strategies to profit from commercial real estate investments. Some funds invest in low-risk rental properties, some simply invest in land or property, and some invest in more speculative development deals.
• Infrastructure. Like REPE, infrastructure private equity can be used to invest in stable, profitable, long-term assets. Infrastructure funds may invest in public utilities, transportation infrastructure, energy plants, or social infrastructure like schools and hospitals.
• Other financial instruments. Some private equity funds invest in other private equity funds or trade in the secondary private equity market.

Generally speaking, a private equity fund will be formed for a specific investment or security and structured around the time frames, financing, and objectives specific to that investment. Investors have significant knowledge, relationships, and control over the company the fund invests in and are active participants in the management and oversight of the company on its journey toward profitability.

Types of Private Equity Investors

Private equity funds are not open to all investors. Private equity funds are typically only available to accredited investors like institutions, or to qualified clients with a high net worth and the ability to have assets remain illiquid for long periods of time.

Investors must make capital commitments initially, and when the fund manager calls for additional investments. The fund typically has significant penalties for investors who default during these capital call periods, or who fail to make catch-up contributions.

Private Equity Fund Structure

A private equity fund is a “closed-end” fund with several structural distinctions. A closed fund structure is focused on investments that cannot be marked to market and is subject to significant restrictions on investor suitability and asset transferability. Portfolio funds are typically carried at cost until a specific time limit or realization event.

Private equity funds are created and managed by a private equity firm, which acts as the fund manager and General Partner. The fund manager recruits investors for the fund’s specific strategy, who then become Limited Partners in the fund. The Limited Partner structure provides liability protection and tax benefits to investors.

Private Equity Fund Allocation and Distribution

A private equity fund is generally distributed to investors only at the end of a fixed period or when the investment has achieved the stated aim, like a sale or an IPO. Interim distributions to help investors cover tax obligations may be made, with “clawback” provisions, should the interim funds exceed the final distributions.

What Is a Hedge Fund?

A hedge fund is a pool of money from private investors, which can purchase a wide range of securities, and use a variety of investment strategies, to generate returns for investors. Hedge funds are famous for using alternative financial instruments to generate returns, including Long-Short strategies. Hedge funds are focused on generating higher than market rate returns in a relatively short period of time.

Types of Hedge Fund Investments

Hedge funds generally invest in stocks and rely on various strategies to outperform the market. Some of the best-known hedge fund investment strategies include:

• Long/Short Equity. The Long/Short strategy involves simultaneously holding long positions in securities expected to increase in value and short positions in securities expected to decrease in value. This strategy aims to capitalize on both rising and falling market prices, potentially reducing risk and enhancing returns. This strategy of reducing risk by investing in both outcomes is also known as “hedging,” which gives hedge funds their name.
• Market Neutral. Most long/short strategies do not hedge all short investments by compensating long ones, leaving risk exposure due to market timing and other factors. The Market Neutral strategy aims to generate returns regardless of market direction by balancing long and short positions. The goal is to eliminate or significantly reduce exposure to market risk while profiting from the relative performance of individual securities.
• Short-Only. Short only hedge funds focus on finding overvalued stocks and generate returns when the value of those stocks fall. While short-only funds are a hedge against a bear market, the strategy is challenged in long term bull markets.
• Convertible Arbitrage. Convertible Arbitrage is a market-neutral investment strategy that aims to profit from the price discrepancies between convertible securities (like convertible bonds) and their underlying stocks.
• Global Macro. Some hedge funds focus on global currency, commodities, or futures markets, taking long/short positions on different asset classes.
• Quantitative hedge funds rely on mathematical and statistical modeling to make investment decisions. Today, most of these funds are driven by machine learning and AI modeling of large data sets, with proprietary algorithms. Quantitative strategies are especially popular with High Frequency Trading tools.
• Event-Driven. Hedge funds may also invest in specific event-driven strategies. Some of the most common event-driven strategies include:
• Distressed companies. A hedge fund manager may seek a distressed company on the brink of announcing bankruptcy and invest in that company’s senior debt, which is most likely to be repaid in the event of bankruptcy.
• Merger Arbitrage. If a merger or takeover is announced, a hedge fund manager may long/shorten both merging companies, investing at the ratio described in the merger agreement.

Types of Hedge Fund Investors

Hedge funds are high risk investments, and have fewer SEC regulations and oversight. For those reasons, they are only open to accredited investors. An accredited investor has a net worth of $1 million or more not including the value of their primary residence, and has an income of at least $200,000/year for the past two years and expects their income to remain the same or increase.

Hedge Fund Structures

A hedge fund is an “open-end” investment fund. Assets are readily marked to market and transferred with few restrictions, allowing easy portfolio rebalancing. They typically do not have a fixed term or commitment period.

Hedge funds have a wide variety of legal structures, and each structure gives investors differing amounts of control over investment decisions, along with different legal considerations and tax liability.

Hedge Fund Performance Measurement

A hedge fund is generally measured by its ability to outperform the relevant market.

The Key Differences Between Private Equity and Hedge Funds

As you can see, there are huge differences between hedge funds and private equity funds. Here is a brief summary of the key differences:

• Long-term, outcome-driven investments vs. short-term, market-driven investments. Private equity firms typically invest in a company with the goal of investing capital and supporting operations until the company achieves profitability or meets some other objective. Hedge funds invest in various markets and financial instruments, making a range of different long- and short-term investments with the goal of generating high returns.
• Active investors vs. passive investors. Private equity funds typically have investors who are familiar with the company and industry, and take an active role in company strategy and guidance. Hedge funds typically have investors who are familiar with markets, and don’t take a role in specific companies or organizations (although they may be in activist hedge funds).
• Fixed-term vs. flexible investment period. Private equity funds are generally formed for a specific period of time or until a specific result is achieved, and their capital is committed for that length of time. Hedge fund investors are free to buy and sell a variety of assets with fewer time commitments or restrictions.

Both private equity and hedge funds are only open to specific types of investors and can pose high financial risks. Both types of funds can also generate high returns and be a powerful way to pool capital, calibrate strategy, and meet financial objectives.

Experienced managers who wish to start a new private equity or hedge fund can face enormous challenges. Not only does the manager need all the skills of an entrepreneur, handling all the aspects of business formation, staffing and contracting, procurement, and marketing, but private equity funds and hedge funds are each subject to a wide range of legal and compliance considerations.

Questions? Contact the Friedman Law Firm Today

Working with a fund formation attorney is essential for correctly structuring the fund, describing the legal relationships between investors and the fund, and defining capital commitments, drawdowns, clawbacks, and other financial obligations. Most private funds also have a legal relationship with an investment advisor, a separate legal entity with its own set of partners and legal and compliance requirements.

To work with a law firm that understands the complexities of corporate law and entrepreneurship, along with the due diligence and regulatory compliance issues of investment funds and securities trading, contact Fridman Law Firm online or call 212-262-9823.