PE Funds vs Hedge Funds
Key Differences Between Hedge Funds and Private Equity Funds
Hedge funds and private equity (PE) funds are both alternative investment vehicles, but they serve distinct purposes within an investment portfolio. While both aim to generate superior returns, their approaches, structures, and operational characteristics differ significantly, primarily due to the type of assets they invest in and their degree of liquidity. This guide explores certain key differences.
Type of Assets Invested
Hedge Funds: Primarily invest in liquid assets, such as publicly traded stocks, bonds, derivatives, and commodities. These assets can be quickly bought or sold in the market.
Private Equity Funds: Focus on illiquid assets, such as private companies, real estate, and infrastructure projects. These investments require longer holding periods to realize value.
Liquidity and Redemption
Hedge Funds: Typically offer investors the ability to redeem their investments periodically (e.g., monthly or quarterly), providing a degree of liquidity.
Private Equity Funds: Do not provide redemption rights. Investors are committed for the life of the fund, which often spans 7-10 years.
Performance Compensation
Hedge Funds: Managers receive a performance allocation, often referred to as incentive fees, based on unrealized profits (e.g., mark-to-market valuations). The incentive fee is usually calculated at the end of each calendar year.
Private Equity Funds: Managers earn carried interest based on realized profits, which are distributed after the underlying investments are sold. This means that managers may not receive carried interest until after a few years have passed following the initial closing of the fund.
Governance and Investor Rights
Hedge Funds: Generally have fewer governance terms because investors retain the right to redeem their capital if dissatisfied with the fund’s performance or direction.
Private Equity Funds: Include more robust governance provisions since investors cannot exit the fund prematurely. These terms may include advisory committees, voting rights on key decisions, key person events and detailed reporting requirements.
Valuation Practices
Hedge Funds: Strike a net asset value (NAV) monthly to facilitate investor subscriptions and redemptions. These valuations are critical for determining the performance allocation.
Private Equity Funds: Provide quarterly or annual valuations. These are less critical since distributions to investors are based on realized cash profits, not on unrealized profits.
Investment Horizon
Hedge Funds: Tend to have shorter investment horizons and may adjust positions frequently in response to market conditions.
Private Equity Funds: Have longer investment horizons, often holding assets for several years to implement value-creation strategies.
Fundraising Period
Hedge Funds: Hedge funds have open-ended structures that allow for ongoing subscriptions throughout the life of the vehicle.
Private Equity Funds: Private equity funds often have a defined fundraising period, after which no new investors can join. The fundraising period is typically 12-18 months from the initial closing date, subject to extension, which may require the consent of the investors. However, the fundraising period is generally no longer than 2 years from the initial closing date.
Fee Structures
Hedge Funds: Typically charge a 2% management fee and a 20% performance fee on unrealized profits (commonly referred to as "2 and 20"), though the performance fee is typically subject to a hurdle rate, which varies depending on strategy.
Private Equity Funds: Charge management fees on committed capital (usually 1.5%-2%) and carried interest on realized profits (typically 20%). The carried interest is typically subject to a hurdle rate (referred to as a “preferred return), which is generally 8% per annum, though this can vary based on the fund’s strategy.
