There is a lot of confusion about the similarities and differences between hedge funds and private equity funds amongst the investing public. I will try to provide a succinct overview of the major differences between the two types of investment vehicles. As this is a quick summary, a lot of information and nuance may be missed. For more in-depth discussions about the topic, please consult an advisor or expert in the space. While hedge funds and private equity funds definitely differ in strategy and implementation, for the most part they are exposed to the equity of companies, and thus should be viewed as part of your equity allocation.
The term hedge fund has evolved from the early days (1940s and 1950s) when hedge funds actually hedged their positions as compared to the general markets. The first funds were relatives of today's long/short funds. Today, though, hedge funds are private investment funds that follow a variety of strategies (Global Macro, Market Neutral, Long/Short, Commodities, etc.), many using leverage in order to generate outsized returns (many times with outsized risks) versus the market. In many ways they resemble less-regulated mutual funds with higher incentive fees. Their performance across time has been shown to be relatively average (with high costs) and many large institutions have begun to pare back their exposure to hedge funds due to poor performance and only marginal diversification benefits. While there are a few funds that do manage to outperform over time, it is hard to identify them in advance and generally they are not available to a retail investor or the market newcomer. The funds tend to have lock-ups and limited liquidity, so in times of crisis, it will be hard to get your money back in a timely manner.
Private equity funds are usually pooled limited partnership vehicles used to make direct investments in private companies. The private equity industry has grown dramatically over the last 25 years with firms like KKR, Bain Capital, Blackstone, The Carlyle Group and others dominating the upper end of the market and many have gone public to access longer term funding at a lower cost than in the private markets. Many went public as publicly traded limited partnerships, but most have now converted to corporate status to appeal to broader segments of the investing world. Private equity investors tend to specialize on an industry segment, geography, company size and/or type of transaction (distressed/restructuring, turnaround, growth, etc.) Limited Partners have historically been university endowments, pension plans, insurance companies, foundations and family offices although there is now talk that defined contribution plans may be allowed to invest in private equity vehicles. (These vehicles will most likely be fund of fund vehicles which tend to have high fees and average performance, in line with or slightly below the average public market index return. Fund of Funds also tend to have lives of 15 to 20 years, so they are definitely only suitable for investors with long time horizons.) With many of the major private equity firms now trading on the public markets, individual investors can get broad exposure to the market segment, although it usually comes along with exposure to real estate and other lending strategies as the large PE houses have grown multiple illiquid investment businesses over the years.
The main differences between the two fund types are that hedge funds tend to invest mainly in securities in liquid markets and have greater liquidity for their investors while private equity funds invest in privately negotiated transactions with private companies and have limited liquidity for their investors during the holding period of the assets. There is a growing secondary market for private equity LP units that makes it easier to sell an LP unit at a point in time, but it is still a negotiated market with private buyers and sellers. Also, while certain hedge funds may build concentrated portfolios, they tend to hold many more investments, and have much higher leverage than a typical PE fund. PE funds on average hold anywhere from 10 to 20 investments and employ leverage at the operating company level, as compared to holding leverage at the portfolio level, as do many hedge funds. This actually reduces the risk of a portfolio implosion at a PE fund as compared to a hedge fund, as the PE debt is secured on a company by company basis and is thus compartmentalized, where as debt in a hedge fund is backed by all of the fund assets. Some private equity firms have started to use debt more frequently at the fund level, especially real estate investors, as interest rates and expected returns on debt like investments have fallen. It is also important to note that in order to make your hedge and private equity fund investments pay off, you need to be invested with the top 25% of managers within a specific year, as the median performance for both types of funds tends to be below that of the public markets. This is hard to accomplish even for professionals in the fund of funds industry. I believe that retail fund of funds in a DC plan will deliver sub-par returns and while fun to talk about at cocktail parties, will fail to live up to their hype for all accept for the fund managers who are earning fees.
Both types of investments can be diversifiers for large sophisticated investors, but are generally not appropriate or necessary investments for smaller, retail investors due to high fees and mediocre performance for the segment as a whole. When investing in both hedge funds and private equity funds access remains the major impediment for most investors in the space. For investors willing to accept public markets risk, investing in publicly traded private asset companies may be the way to go.
Please consult with a trained investment professional before making any investments in private equity or hedge funds. The information included in this article should not be considered investment advice and should not be relied upon for any investment decisions. The opinions expressed herein are those of the the author and no one else.