Barden Financial Services Asset Management Series...Hedge Fund v Private Equity: What do they do?
Welcome to the first of the newly launched Barden Financial Services Asset Management Blog Series. Each blog aims to deliver asset management focused content, to demystify and decode some of the tricky terminology out there, and to shine a light on asset management as a career.
As the experts in financial services recruitment we regularly field questions about asset management, and in particular hedge funds and private equity.
In this edition Fionnán O’Sullivan, Director, Barden Financial Services, zones in on what hedge funds and private equity actually do, and the key differences between both.
Hedge Fund v Private Equity: What do they do?
Both hedge funds (HFs) and private equity (PE) firms are classified as “alternative investments” and share some high-level similarities.
For example, they both raise capital from outside investors, called Limited Partners (LPs), and then invest that capital into companies or other assets.
They attempt to earn a high return, and in exchange, they take a percentage of that return for their performance fee.
They also charge a management fee on the total amount of capital raised.
After that, however, almost everything else is different.
What’s the Biggest Difference?
The biggest difference is that PE firms tend to acquire entire companies using equity and debt, while HFs acquire very small stakes in companies or other liquid, financial assets such as bonds, currencies, commodities, and derivatives.
As a result, PE firms have a long-term focus (often 3-5+ years for individual companies) and spend more time on operations and growth for their portfolio companies.
Hedge funds focus on finding mis-priced financial assets and benefiting from quick gains in near-term, 12-month periods.
Because of this longer-term focus, PE firms require longer lock-up periods from their LPs, while redemptions are easier at HFs.
Is There a Difference When It Comes to Fees?
While both types of firms have management fees and performance fees, hedge funds usually charge lower percentages for both because of market factors and poor post-financial-crisis performance.
Private equity fees have fallen a bit over time, but they’ve remained close to the traditional “2 and 20” model – a 2% management fee and 20% performance fee – while the average hedge fund now charges a management fee of under 1.5% and a 15% performance fee.
And the trend is toward even lower management fees, with performance fees that scale up or down based on annual returns.
Finally, “performance” is measured differently; it’s linked to Internal Rate of Return (IRR) and hurdle rates at PE firms, but net asset value (NAV) relative to the high-water mark at hedge funds.
So, if the fund’s previous highest NAV was €200, and it ends this year at €180, the performance fee will be €0 even if the fund earned a positive return this year.
That exists because LPs don’t want to pay fees on returns that offset losses from previous years.
As you can see there are a number of differences, and also similarities between hedge funds and private equity. We’re just touching the tip of the iceberg when it comes to hedge funds and private equity. Keep an eye out for our upcoming blogs in the Barden Financial Services Asset Management Series which will take a closer look at hedge funds and private equity “Nature of the work” and “Skills and career requirements”.
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