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Private Equity and Hedge Funds: They’re not the same
Introduction
In the minds of some, private equity funds and hedge funds are the same. In fact, there are fundamental differences between these two important sectors of the global financial markets.
Private Equity Funds
The term “private equity” encompasses a range of investments that are not freely tradable (thus they are illiquid) on a public stock market. Private equity funds are classified into two types: venture capital funds and buyout/growth capital funds. However, nowadays the term private equity refers usually to the buyout/growth capital segment of the market.
Venture capital firms and private equity firms generally obtain their funding from the same sources: public and private pension funds, foundations, university endowments, and other knowledgeable investors. Venture capital firms fund start up and fund young companies with little or no track record. In contrast, buyout/growth capital funds invest in mature companies with the intent of owning and operating them for several years or more with the goal of growing them quickly, turning them around, or otherwise improving their performance. Private equity firms typically create value by improving the operations, governance, capital structure, and strategic position of the companies in which they invest.
Hedge Funds
In contrast, hedge funds are a loosely defined category of investment pools that, like a retail mutual fund, principally invest in publicly traded securities, currencies or commodities. However, where most mutual funds typically own “long” positions in securities, i.e. they actually own the security with the hope it will rise only in value, a hedge fund may make “long” investments, take “short” positions betting on a company’s stock price to fall, and engage in many more complex trading strategies, including: futures trading, swaps, and sophisticated derivative contracts.
Private Equity Funds And Hedge Funds: Key Differences
Private equity funds and hedge funds both typically are sold in private offerings to sophisticated investors and require large capital commitments for participation (frequently $5 million or more). But the differences, reflecting the very different roles they play in capital markets, are many.
Investment Horizons:
- Private equity firms are long term investors. They buy major stakes in companies, and exercise control over those companies for the duration of their investment (2-5 years and sometimes much longer).
- Hedge funds usually liquidate investments over shorter horizons.
Control:
- Private equity firms gain control of the companies they buy in order to implement governance and operational improvements during their period of ownership. Sometimes they have outright majority ownership (either alone or with other private equity funds) and nearly always they have at least one representative on the board of directors.
- Hedge funds are usually minority shareholders who do not exercise control over the companies in which they invest.
Exiting Investments:
- Private equity companies sell the companies they own once their value has increased, usually by floating stock as an IPO on the public stock markets or selling to another buyer (which could be a company or even another private equity firm).
- Hedge funds simply sell the securities they purchase on the major exchanges when they believe their investment strategy has played out.
Capital Flow:
- Private equity firms raise capital specifically for each fund, invest it, return the gains and the principal to their investors and then start a new fund-raising cycle. A typical private equity fund life is ten to twelve years. Investors may not request that their funds be returned early.
- Hedge funds are “evergreen,” i.e., capital committed stays in the fund and may be invested over and over for further returns until requested back by the investor. Hedge fund investors put in their money at the time of investment, whereas a private equity fund calls capital from time to time as investments are made by the fund.