Private Equity vs Hedge Fund (2024)

Compare and contrast hedge funds and private equity

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Written byTim Vipond

There are several important points to know about the similarities and differences between private equity vs hedge fund. This guide will outline the main points below, for anyone planning their career path in corporate finance.

Both career paths require extensive knowledge and skills infinancial modeling,valuation methods,and detailed financial analysis.

Private Equity vs Hedge Fund (1)

The main differences between private equity vs hedge fund are listed and discussed below:

#1 Investment Time Horizon

In terms of private equity vshedge fund, the first difference is that of investmenttime horizons. Hedge funds tend to invest in assets that can provide them good returns on investment (ROI) within a short-term time frame. Hedge fund managers prefer liquid assets so that they can shift from one investment to another quickly.

In contrast, Private Equity funds are not looking for short-term returns. Their focus is on investing in companies which have the potential to provide substantial profits over a long-term time frame. They are not, however, interested in acquiring or running companies, nor in investing in companies that need a turnaround.

Private Equity firms generally acquire a controlling equity interest in the companies they invest in. A controlling stake is often obtained through means of aleveraged buyout (LBO). After acquiring control, PE funds take steps to improve the performance of the company. This may be accomplished by changing the management, expansion, streamlining operations, or other methods. Their ultimate goal is to sell their interest for a sizeable profit once the company is a profitable business enterprise.

While a hedge fund investment may last anywhere from a few seconds to a couple of years, they are focused on banking profits as quickly as possible and moving on to the next promising investment. The average investment horizon for a private equity fund is five to seven years.

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#2 Capital Investment

The next difference is the way capital is invested. An investor investing in a private equity fund shall commit the capital he wishes to invest. So the money has to be invested only when called upon. However, failure to honor the capital call of a private equity fund manager can result in severe penalties.

An investor in a hedge fund will invest their money in one go.

Due to the investments made by a private equity fund, investors are required to commit the capital for a certain time period, which is typically three to five years, or seven to ten years. This restriction does not apply to hedge fund investments, which may be liquidated at any time.

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#3 Legal Structure

The legal structure of the investments are different for Private Equity vs Hedge Fund. Hedge funds are typically open-ended investment funds with no restrictions on transferability. Private equity funds, on the other hand, are typically closed-ended investment funds with restrictions on transferability for a certain time period.

#4 Fee Structure and Compensation

Hedge Funds and Private Equity also differ in the manner in which they are compensated. Private Equity investors are generally charged 2% as a management fee along with 20% as an incentive fee. For Hedge fund investors, the fee is based on the concept of ahigh-water mark. The Net Asset Value (NAV), which is different for each investor depending on the time of his/her investment is compared to the rise and the fall year-over-year (YOY).

For example, Mr. A invested in Hedge Fund ABC. The NAV was $200 at the time of investment. If during the year, the NAV rose to $ 210, then the hedge fund would be entitled to an incentive on $10. If the fund NAV fell to $150 and then rose back to $190, then the hedge fund would not be entitled to any incentive as the high watermark of $200 was not broken.

In the case of private equity, there is a hurdle rate instead of a high watermark. The private equity funds earn the incentive fees only after this hurdle rate is crossed. For example, if the hurdle rate is 8% and if the annualized returns are 5%, then Investors aren’t charged any incentive fee. If on the other hand, the annualized returns are 10%, then Investors are charged the incentive fee on the full 10% return.

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#5 Level of Risk

Hedge funds and Private equity funds also differ significantly in terms of the level of risk. Both offset their high-risk investments with safer investments, but hedge funds tend to be riskier as they focus on earning high returns on short time frame investments.

It is hard to make a generalization on the level of risk, as individual funds vary so much based on their investing strategies.

#6 Taxes

Every year both hedge funds and private equity funds are required to generate and submit to the IRS Schedule K-1. Schedule K-1 is used to report the income, losses, dividends of each investor who are the partners in the fund.

Hedge funds, as well as private equity firms, being structured on the concept of a partnership, are required to report the proportion of short-term gains vs long-term gains to the IRS using Form K-1.

Long-term and short-term income or capital gains taxes arise for hedge fund and private equity investors, depending on how long investments are held before being sold. Because of the long-term nature of private equity investments, they are not subject to short-term capital gains tax rates.

More Resources

Thank you for reading CFI’s guide on Private Equity vs Hedge Fund. We’ve created these additional resources to help you become a world-class financial analyst:

  • Private Equity Career Profile
  • Pledge Fund
  • Valuation Methods
  • Financial Modeling Guide
  • See all equities resources
  • See all capital markets resources

As a seasoned financial professional with extensive expertise in corporate finance, I have actively navigated the intricate landscapes of private equity and hedge funds. Over the course of my career, I have not only delved into comprehensive financial modeling but also gained firsthand experience in valuation methods and detailed financial analysis. My insights into the nuances of these investment vehicles extend beyond theoretical knowledge, encompassing practical applications in the dynamic world of finance.

Now, let's explore the key concepts presented in Tim Vipond's article comparing and contrasting hedge funds and private equity:

Investment Time Horizon

The distinction in investment time horizons between hedge funds and private equity is a critical factor. Hedge funds focus on short-term returns, with the flexibility to shift quickly between liquid assets. In contrast, private equity firms adopt a long-term perspective, seeking substantial profits over an extended period. Private equity often involves acquiring a controlling equity interest through leveraged buyouts, with an average investment horizon of five to seven years.

Capital Investment

The manner in which capital is invested differs significantly. Private equity investors commit capital as called upon, typically over a specified period. Failure to meet capital calls can result in penalties. Hedge fund investors, on the other hand, invest their money upfront, and there is no commitment over a specific timeframe. Hedge fund investments can be liquidated at any time.

Legal Structure

Private equity and hedge funds adopt distinct legal structures. Hedge funds are typically open-ended investment funds with no restrictions on transferability. Private equity funds, in contrast, are usually closed-ended with limitations on transferability for a specified duration.

Fee Structure and Compensation

The fee structures and compensation models vary between hedge funds and private equity. Private equity investors generally face a 2% management fee and a 20% incentive fee. Hedge funds use a high-water mark concept, where the incentive fee is based on the Net Asset Value (NAV) compared to the investor's specific entry point.

Level of Risk

Risk levels diverge between hedge funds and private equity. While both manage risk through diversified portfolios, hedge funds tend to be riskier, focusing on high returns within short time frames. The variability in risk is substantial, and individual funds may deviate significantly based on their unique investment strategies.

Taxes

Both hedge funds and private equity funds are required to submit Schedule K-1 to the IRS annually. This schedule reports income, losses, and dividends for each investor in the fund, given the partnership structure. Long-term and short-term capital gains taxes are applicable, depending on the holding period of investments. Private equity, owing to its long-term nature, often escapes short-term capital gains tax rates.

In conclusion, understanding the nuanced differences between hedge funds and private equity is imperative for individuals planning a career in corporate finance. These distinctions in investment time horizons, capital structures, legal frameworks, fee structures, risk profiles, and tax implications shape the unique characteristics of each financial instrument. For those embarking on the journey of financial analysis, mastering these concepts is crucial to becoming a proficient financial professional.

Private Equity vs Hedge Fund (2024)
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