While hedge funds and private equity firms both are grouped under the alternative investment umbrella, there are key differences in the way they operate. Hedge funds use investment strategies -- often to earn a quick profit -- across asset classes. Private equity firms are deal-makers. They invest capital in businesses in the private sector. Private equity capital is also used to bring companies that once traded in the public stock market into the private domain, where businesses face less scrutiny from public investors.
Hedge funds are run by market traders. These investment professionals move in and out of financial securities searching for the best possible profits. Hedge fund managers take high risks in the financial markets to generate high profits. Private equity firms invest in businesses either by purchasing them outright or by acquiring select assets. Often, the businesses in which private equity firms invest are troubled, and the investors seek to improve upon performance using their own expertise. Eventually, private equity firms seek an exit strategy through which they sell investments to strategic companies or pursue an initial public offering.
Prior to the financial crisis of 2008, both private equity firms and hedge funds used similar fee structures -- charging investors 2 percent of assets managed and 20 percent for performance. Both asset management groups were willing to make certain compromises following the recession when investment performance suffered. Private equity firms began directing an average of 83 percent of deal fees they earned from portfolio companies to investors, some 13 percent better than pre-crisis days, according to a 2011 article on "The Economist" website. In 2008, at the height of the financial crisis, certain hedge funds lowered fees by 1 percent and 5 percent for management and performance, respectively, according to a 2008 article on the Bloomberg website.
Liquidity represents an asset manager's ability to access cash. While private equity funds and hedge funds are both considered less liquid than traditional investment vehicles, private equity funds are the least liquid of the two, according to findings by the Advisory Council on Employee Welfare and Pension Benefit Plans cited on the U.S. Department of Labor website in 2011. Additionally, the current value of assets is harder to assess in a private equity portfolio versus a hedge fund due to the nature of the assets that private equity funds hold.
In exchange for fees that are higher than rates that traditional asset managers charge, alternative asset managers are expected to produce returns that trump those delivered elsewhere. Nevertheless, in the first 11 months of 2012, average hedge fund returns of just under 5 percent paled in comparison to the 12 percent delivered by broader market indexes, according to a 2012 article on the Reuters website. In the first quarter of 2012, private equity returns similarly underperformed the broader markets, generating profits of just over 5 percent versus nearly 13 percent returns produced by the S&P 500 index, based on data provided by investment consultant Cambridge Associates cited in a 2012 article on the Pensions and Investments website.
- The Economist: Fee High So Dumb
- Bloomberg: Hedge Funds Lower Fees, Lengthen Lockups on New Funds
- Reuters: Hedge Fund Masters Flunk Money-Making Test
- Pensions and Investments: U.S. Private Equity Returns 5.4 Percent in Q1, Says Cambridge
- U.S. Department of Labor: Hedge Funds and Private Equity Investments
Geri Terzo is a business writer with more than 15 years of experience on Wall Street. Throughout her career, she has contributed to the two major cable business networks in segment production and chief-booking capacities and has reported for several major trade publications including "IDD Magazine," "Infrastructure Investor" and MandateWire of the "Financial Times." She works as a journalist who has contributed to The Motley Fool and InvestorPlace. Terzo is a graduate of Campbell University, where she earned a Bachelor of Arts in mass communication.