Even though investor profiles are often very similar, there are huge differences when it comes to the goals and types of investments pursued by hedge funds and private equity funds.
Both hedge funds and private equity funds are attractive to high net worth individuals. They are also both structured as limited partnerships, with payments to the managing partners, such as basic management fees and a percentage of profits.
What are Hedge Funds?
Hedge funds are alternative investments that use pooled funds and use different strategies to gain some profits for their investors.
The goal of hedge funds is to provide the highest possible returns as quickly as possible. To attain such goal, hedge fund investments are primarily highly liquid assets.
This enables the fund to take profits quickly on one investment and then switch the funds into other investments that are more promising.
Hedge funds are also known for their use of leverage, or borrowed money, to increase their returns. However, this kind of strategy poses huge risks, as seen in the 2008 financial crisis.
Hedge funds may invest in anything and everything, including individual stocks, commodity futures, bonds, currencies, arbitrage, and many other assets, depending on the fund manager, who searches for high potential returns in a short period of time.
Hedge funds are seldom accessible to the majority of investors. Rather, hedge funds are focused on accredited investors, which need less SEC regulation than other types of funds.
Private Equity Funds
Private equity funds are mostly similar to venture capital firms in that they invest directly in companies, primarily by purchasing private companies.
However, they also sometimes try to acquire controlling interest in publicly traded companies through stock purchases.
They also often use leverage buyouts to acquire financially distressed companies.
Not like hedge funds, which are focused on short-term profits, private equity funds are focused on the long-term potential of the portfolio of companies that they hold an interest in or acquire.
To attain these goals, private equity funds usually have a group of corporate experts who can be designated to manage the acquired companies, in addition to fund managers.
The nature of their investments requires a more long-term focus, looking for profits on investments to mature in a few years instead of having the short-term quick profits.
Other Key Differences
Hedge funds focus on many liquid assets. That means investors can often cash out their investments in the fund at any time.
For comparison, the long-term focus of private equity funds often requires investors to commit their funds for a minimum period of time, usually at least three to five years. Often, it lasts from seven to ten years.
You can also find a huge difference between the risk levels in hedge funds and private equity funds.
Although both of these funds practice risk management by combining higher risk investments with safer ones, the focus of hedge funds necessarily involves accepting a higher level of risks.
There are hedge funds that fit the traditional definition, too, and they are funds created to provide protection of capital in traditional investment. However, these days, this is no longer the case with hedge funds.