At one time, Private Equity and Hedge Funds were the somewhat secret investments of the super rich. While these investments still target the very wealthy, the proliferation of funds and competition for investors has meant the minimum net worth requirements have loosened and more people than ever have bought into these assets.
Private Equity, as the name implies, is a fund composed of money from individual and institutional investors that is used to make investment most often in private companies. These funds became famous in the 80’s for the leveraged buy-outs that took public companies private (removed them from the stock exchange and put the ownership concentrated in the hands of the Private Equity company rather than dispersed widely to individual investors). At that time, the standard mode of operation of KKR and other Private Equity funds was to buy public companies and take them private using a small amount of equity and a large amount of debt. They would then drastically cut costs to make the entity more profitable and sell it or sometimes break up the entity as the sum of the parts were worth more than the company as a whole. At the time, they were notorious and very feared by companies who had been slow to adapt.
Times have changed and while Private Equity may still be involved in leveraged buy-outs, they are most often focused on looking for companies that have strong cash flow that could use investment capital to make them even stronger. They then buy the company, invest the money and then try to sell the stronger company in 3 to 5 years, returning the gains to the Limited Partners who contribute to the fund.
As a Limited Partner, you make a capital commitment to the fund that gets called in the event of a transaction. You then own a piece of the target through the fund and get a return if and when the company is eventually sold. Since the fund will have a number of holdings, your return will be a function of the average return from all the investments on aggregate. Typically investors must commit their funds for a minimum period of time – at least 3 to 5 years and often 7 to 10 years.
In return for finding and executing on the transactions, governing the acquired companies (typically through a Board seat) and managing the fund, the Private Equity company will often take a fee commonly set at 2/20 – or 2% of the capital commitment per year plus 20% of the return (called the “carry”) at a certain level of return.
Hedge Funds are similar to Private Equity in that they take money from investors to create a fund that they use to make investments. They both have similar legal structures and target similar investors (high net worth individuals, family offices and sovereign funds). The fee structures are also similar.
However, the investment focus is different. Where a Private Equity firm typically seeks to invest directly in companies, typically through the purchase of private companies, Hedge Funds invest in virtually anything including individual stocks, bonds, options, currency and derivatives. The goal of a hedge fund is to deliver a strong return over a short period of time. Therefore, a Hedge Fund typically gets involved in more risky investments, hoping to convert that to a higher return.