Many investment professionals aspire to form and operate their own private investment fund. This article will briefly outline two of the more popular types of funds: private equity funds and hedge funds.
At a high level, private equity funds and hedge funds share similar characteristics. Each type of fund seeks to pool funds from investors and make investments. Each are typically structured as either a limited partnership (LP) or limited liability company (LLC), and are managed by the entity’s general partner or managing member, respectively. In addition, from a securities law standpoint, each type of fund typically takes advantage of certain exemptions from securities registration with the Securities and Exchange Commission (SEC), namely Section 3(c)(1) and 3(c)(7) under the Investment Company Act of 1940 to avoid having to be registered as an investment company under such Act.
Despite these similarities, each type of fund is considered a wholly distinct asset class. The following highlights important differences.
1. Type of Investment
Private equity funds typically invest in illiquid investments in private companies. Hedge funds typically invest in liquid investments in publicly traded companies, mixed with “side pockets”, which are separate accounts established within the fund to separate certain illiquid investments in the fund’s portfolio.
2. Duration of the Fund
Private equity funds generally have a fixed term dictated by the redemption or liquidation timeline of the fund’s private investments. Hedge funds typically have a term that is perpetual.
3. Admission of Investors
Private equity funds are typically a “closed-end investment vehicle”. This means the fund conducts one or more closings, and after the initial closing, new investors are not permitted to subscribe to the fund, or if the fund permits additional investors, the later investors are usually charged interest on their investment in order to compensate earlier investors. Upon subscription to the fund, investors commit to invest a certain amount of capital (but do not necessarily remit funds at this time) and make cash outlays over time as the general partner of the fund issues capital calls in order to make investments or for fees and expenses.
Hedge funds are typical an “open-end investment vehicle”. This means that investors may invest in the fund throughout the life of the fund, and are generally admitted on a monthly or quarterly basis. At each subscription of new investors, the investors subscribe at the fund’s Net Asset Value (NAV).
4. Withdrawal of Investors from the Fund
In private equity funds, investors are generally not permitted to withdraw early from the fund unless their continued participation would violate applicable law.
Investors in hedge funds are generally permitted to withdraw from the fund on specified redemption dates (monthly, quarterly, semi-annually). In order to protect the integrity of the fund, redemptions oftentimes are restricted in certain ways. For example, if an investor desires to redeem its interest from the fund, such redemption may require advance notice to the general partner, may be subject to a minimum redemption amount, may be subject to a lock-up period in which the investor is prohibited from redeeming its investment, or the redemption may be subject to certain “gates” by which the investor may be prohibited from redeeming its investment if the redemption amount exceeds a certain percentage of the fund’s Net Asset Value (NAV).
5. Investor Default on Capital Commitments
In private equity funds, since the general partner typically makes capital calls over time to fund investments (rather than at the fund’s closing), there is risk that an investor may default in making its agreed upon capital contribution. Since investments in hedge funds are funded immediately upon subscription, investor default is not a risk.
6. Distributions to Investors
In private equity funds, cash distributions are made to investors as investments are realized. The fund’s distribution waterfall provides that proceeds from realized investments are made in order of tiered priority. A standard distribution waterfall provides that before the general partner receives proceeds from realized investments, investors first receive their initial investment back and then are given a preferred return on their investment. Once these tiers are satisfied, the general partner keeps all the profit until its carried interest percentage is reached, and thereafter the profits are split between the general partner and the investors (typically 20% and 80% respectively).
Distributions are typically not made in hedge funds. Investors receive their realized investment upon redeeming their interest or the fund dissolving.
7. Management Fees
In private equity funds, the general partner typically charges an annual management fee (paid quarterly or semi-annually). This fee is calculated based on capital commitments made during the commitment period and contributed capital following the commitment period.
Hedge fund management fees are typically calculated annually and paid out quarterly or semi-annually. The fee is calculated based on the fund’s Net Asset Value (NAV).
8. Performance Fees
In private equity funds, the general partner is typically rewarded for fund performance in the form of carried interest. The general partner receives carried interest only when the fund achieves profits above a certain agreed-upon rate of return on committed capital.
For hedge fund managers, an annual performance allocation (i.e., performance fee) is calculated based on increases in the fund’s Net Asset Value (NAV). This amount is typically subject to a “high water mark”, where any decrease in the fund’s NAV must be accounted for by the general partner before receiving the performance fee. Many funds also require that the performance fee be subject to a hurdle rate, that is, the fund must achieve a certain rate of return before the performance fee is assessed.
9. Valuation of Investments
In private equity funds, investments are valued when they are sold or realized. Prior to these events, investments are difficult to value because they do not have an ascertainable market value.
In hedge funds, investments generally have an ascertainable market value. As such, valuations are typically conducted periodically, most often when investors redeem their interest in the fund.
Concluding Thoughts
The categories above highlight some of the most important and readily ascertainable differences between private equity funds and hedge funds. This list is not exhaustive, but hopefully highlights important considerations for investment professionals.
