Private equity and hedge funds are both attractive options for high-net worth individuals, with many requiring a minimum of $250,000 in investments. However, while they have a couple of similarities, the two are fundamentally different types of funds.
Sometimes it’s unclear which of the two is the better option.
Let’s look at the key differences, as well as how the recession and recent legislation have affected both the immediate and long-term attractiveness of private equity and hedge funds as investment vehicles.
What’s the difference between private equity and hedge funds?
A private equity fund is a capital amount that an investor invests in a business with the aim of gaining equity ownership in the business. The funds are applied for different purposes, such as improving the balance sheet or ensuring smooth operations.
On the other hand, hedge funds (also referred to as investment partnerships) are focused on giving the investor an attractive investment vehicle that’s typically uncorrelated with the larger market. To achieve this, hedge funds typically specialize in a specific type of investment, usually in highly liquid assets all the way to esoteric illiquid securities. This allows the fund to gain a profit even in a bear market.
Unlike hedge funds, private equity is illiquid. Investors may not be able to recoup their money until a company has an exit.
Private equity funds are closely related to venture capital, and have similar long-term growth and exit goals. These kinds of investments are also uncorrelated with the market but are usually long-term, typically taking a minimum of 3–10 years before sale of assets. Accredited investors and institutional investors are most common to private equity, mostly because they best understand the implications and can afford to keep funds invested for long periods of time.
While both types of funds take measures to manage risk, hedge funds are usually more exposed to risk since they focus on short-term gains and mark to market. However, while a hedge fund manager can shield investors by anticipating profit levels basing on current conditions, private equity is highly speculative and investors often don’t know what their returns will look like until years later.
Private equity investment requires large capital commitments. Most private equity firms typically want investors who are willing to commit upwards of $25 million. Some firms have however dropped their minimum requirements to $250,000––which might still be out of reach for many average investors.
Hedge funds usually require a lower minimum of $100,000. But many hedge funds will require$1 million as the minimum investment––still nowhere near $25 million, though.
Both funds have a similar fee structure, and typically require a management fee and a performance fee. The annual management fee for private equity firms is around 2% with a performance fee (or carried interest) of around 20% of the investment profits.
The “Two and Twenty” phrase is used in the hedge fund world to convey that hedge fund managers typically charge a 2% flat fee of the total value of assets and 20% performance fee on earned profits. However, in some cases, the 20% fee is charged only after the performance exceeds a certain threshold, which is typically around 7-8%.
What do investors expect from each type of firm?
Governments and regulators have reinforced the regulations of private equity firms, citing what was seen by many as over-favorable taxation. Investors have also pressured the industry to provide more transparency regarding fees and expenses. These new regulations will see investors deal with more transparent fund managers moving forward.
The current regulatory environment also presents a new set of challenges to hedge fund managers. Not only have they had to come to terms with the Dodd-Frank Act, they also have to comply with new registration and disclosure requirements. Investors are now more proactive in the selection and redemption criteria and are more likely to try and negotiate management fees as well.
In light of these new regulations, we can expect to see fund managers become more transparent and investors tighten -up their due diligence.
What’s the current outlook for private equity and for hedge funds?
In the past, private equity has maintained a track record of outperforming all other asset classes; this is generally has not been the case recently. Recently, hedge fund returns have shrunk due to rising competition, market conditions, and regulation. Some critics argue that it’s unlikely hedge funds will return to their peak levels.
But things aren’t all bad. According to a McKinsey & Company post by Sacha Ghai, Conor Kehoe, and Gary Pinkus, “Industry performance is better than previously thought, but success is getting harder to repeat. Investors and firms will need to adapt to changing conditions.”
As institutional investors and high net worth individuals are expected to make bigger commitments in private equity, a study conducted by Barclays last year found that 48% of investors plan to make more allocations into hedge funds this year. This is an improvement compared to the 33% who voiced similar intentions in 2015.
The report goes on to say that while the asset level reached a new high last year, the industry also experienced outflows for the first time since the 2008 financial crisis. However, the report continues, there’s promise for net inflows in 2017.