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Private Equity vs. Hedge Funds: Similarities and Differences

June 21, 2022
6
min

Private equity funds and hedge funds are both structured as pooled investments of institutional investors. But the types of investments each fund makes are different.

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In 1992, the hedge fund Quantum Investment Fund headed by philanthropist George Soros bet $10 billion against the British pound. When the value of the pound plunged, he made more than $1 billion for himself in a single day. It’s considered one of the most audacious speculative moves ever by a hedge fund.

Private equity (PE) deals can be equally dramatic. The $25 billion record-making leveraged buyout of RJR Nabisco in 1998 by private equity firm Kohlberg Kravis Roberts & Co. (KKR) was at the time the largest LBO in history. The CEO of RJR Nabisco started a negotiation with Shearson Lehman Hutton to auction off the company, a proposal the company’s board rejected outright. When the board issued a press release, the company opened itself to a bidding war, and was ultimately bought out by KKR in a highly leveraged deal.

Both private equity and hedge fund deals are considered alternative investments, but they invest in different kinds of assets and work over different time periods. Private equity funds acquire entire companies, working to increase the value of their investment for up to a decade before exiting their investment. By comparison, hedge funds buy liquid assets—like currency, bonds, or commodities and even antiques—that can be turned around in the short-term, for a quick profit.

What is private equity?

Private equity is the capital that partners in a private equity fund invest to acquire ownership in a company. This form of financing takes place outside the public financial markets. Typically, the partners either buy a public company, take it private and restructure it, or buy a private company and prepare it for an initial public offering (IPO). Private equity funds work to increase in value of the company and usually operate along a three- to five-year timeline. They exit their investment when selling the company or when the company IPOs, then distribute the profits among themselves.

The partner groups in a private equity deal are divided into general partners and limited partners. General partners have full liability for the investment (including debts), hold minority shares in the portfolio company, and earn fees for managing the company’s growth. Limited partners are high-net-worth individuals, public or corporate pension funds, endowments, or foundations that invest in the fund with limited liability and majority shares. 

What is a hedge fund?

Hedge funds, also called investment funds, can also raise capital in private—outside the public financial markets—from limited partners. They also charge management fees and performance fees on the investments they make.

The goal of hedge fund managers is to make as large a return as quickly as possible. So rather than buying entire companies, they tend to invest in highly liquid assets, such as stocks and bonds, currency, and derivatives. Typically, hedge funds use leverage, or borrowed capital, in an attempt to increase their returns. For instance, when Soros shorted the British pound, he borrowed $10 billion to convert pounds into different currencies. Once the pound fell, he could buy back the pounds he owed at a better rate, pay back his lenders, and keep the difference.

PE vs. hedge funds: How they’re similar and different 

Both hedge funds and private equity funds are considered alternative investments. They are structured as partnerships, usually among high-net-worth individuals and corporate investors, and pay their managing partners a management fee and a percentage of profits. Neither is registered with the Securities and Exchange Commission (SEC), so there are less regulatory hurdles when compared to, say, mutual funds. But there are significant differences in where they invest and the strategies they use. 

Investing strategy

Hedge funds can invest in a wide variety of assets, like venture capital, derivatives, or even NFTs, using hedging strategies against the investment risk of one with investment in another. The strategy is meant to make the fund money regardless whether markets are up or down. But since hedge funds aim to make high returns on short-term investments, hedge fund investors must accept a higher level of risk.

The PE fund’s strategy is longer-term: growing their portfolio company’s value and exiting at a profit.

How they work with companies

Both PE funds and hedge funds can invest capital in companies. But while PE firms typically take a controlling equity interest in their portfolio companies, hedge funds do not buy companies outright. A hedge fund’s aim is usually to take profits as quickly as possible and move on. So where a PE firm’s investment in a company may be up to a decade or more, a hedge fund’s investment—and divestment—may be quick. 

Activist hedge funds are a notable exception to this general rule, as they may take a more hands-on role in influencing the course of the company while they hold a large stake in the business. 

How performance is measured

Both types of funds measure their performance based on their return on investment (ROI), but they use different metrics to determine their return on investment. 

Among other metrics, PE funds typically measure their performance using a measure of the Internal Rate of Return (IRR), which is the estimated compound annual rate of return on an investment. A PE firm typically looks to make an IRR of 20-30%, and typically measures its hurdle rate, or the cost of capital, against its IRR. 

Hedge fund managers typically compare assets with different levels of risk. For instance, a hedge fund manager might use the Sharpe Ratio to factor in risk and compare it to another asset.

Manager compensation

Managers of PE and hedge funds are both compensated in management fees and performance fees.  PE fund general managers typically make a 2% management fee, and are paid an incentive fee (typically around 20%) after a hurdle rate—or a minimum rate of a return—is reached. Hedge fund managers usually make 1% to 2% of the fund’s net assets in management fees and take between 15 to 20% of each investor’s net profits for each calendar year in performance fees above the “high water mark,” or the highest value the account has reached.

Who can invest 

Both types of funds attract high-net-worth investors. In fact, only accredited individual or institutional investors are entities allowed to buy or invest in securities that are not registered with financial regulatory agencies, or can invest in private equity or hedge fund partnerships. 

The bottom line

Private equity funds and hedge funds are both structured as pooled investments of institutional and high-net-worth investors. Their fund managers make a fee for managing these investments, and make more money when the investments generate profit. 

But the types of investments each fund makes is different. Private equity firms invest in companies with the goal of growing a company to sell it or take it public, and then exit the investment and distribute profits. Hedge funds make multiple investments beyond companies and in highly liquid securities using leverage and short selling. Because these investments are shorter term, hedge funds typically take on more risk than PE funds.

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