Hedge funds and private equity are alternative investment funds that the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 regulates. They are high-risk investments that invest in marketable securities and private companies. Though both hedge funds and private equity funds are alternative investments, they differ based on investment structure, horizon, expense ratio and taxation. This article covers hedge fund vs private equity in detail.
What are Hedge Funds?
Hedge funds are investment vehicles that pool money from multiple investors and invest them according to a strategy. These funds can be Limited Liability Partnerships (LLP) or Limited Companies formed by either a money manager or Registered Investment Advisor (RIA). Hedge funds were initially formed to hold both long and short stock positions to hedge risk. Therefore, hedge fund investors would earn money no matter how the market goes. However, over a period of time, they include all types of capital investments.
Hedge funds are alternative investments that pool money from High Net worth Individuals (HNIs) having similar objectives and invest in shares, private equities, debt, real estate, currencies, commodities, etc. Hedge funds tend to offer a higher return, however, at a higher risk. These funds fall under Alternative Investment Funds Category III. Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 regulates these funds.
The minimum investment in a hedge fund per investor is INR 1 crore. Also, it would need a minimum corpus of INR 20 crores to start the fund. The hedge fund expense ratio consists of management fee and performance-based fee ratio. The management fee is usually around 2%, and the performance fee is anywhere between 10%-20%.
Capital gains on hedge funds are taxable at the fund level. In other words, the individual investor does not have any tax liability. However, this means the fund deducts taxes from the investors’ profit, hence automatically reducing the returns for the investors.
Can You Invest in Hedge Funds?
High net worth individuals, institutional investors, banks, insurance companies, pension funds and endowments can invest in hedge funds. Hedge funds are privately managed funds. Therefore, they are on the costlier side. Hence, they are affordable only for the financially well off. The minimum ticket size for investing in Hedge funds is INR 1 crore. However, having surplus money isn’t enough to invest in these funds. Investors should be willing to undertake a significant amount of risk.
The fund manager aggressively buys and sells securities to keep up with the changing market dynamics. Furthermore, these funds have a higher expense ratio that is often in the range of 15 to 20 percentage of the investor’s returns. Even though experts manage the fund, it is advisable to proceed with caution. Also, unless and until one is confident and willing to undertake the risk and costs that come with hedge funds, it is better if first-time investors proceed with caution.
What are Private Equity Funds?
Private equity is a type of alternative investment fund that falls under the AIF Category II. They primarily invest in unlisted companies. Private equity funds also participate in buyouts of public companies that result in the delisting of the company. Private equity firms usually provide initial investments for new companies, including seed capital, venture capital, and angel investments. Hence private equity firms get ownership in the companies.
In India, the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 regulates private equity. Private equity funds are closed-ended alternative investment funds that do not accept any investments after the initial period’s expiration. These funds’ investment horizon is usually around seven to ten years as they usually invest in early-stage companies. Private equity investments are less riskier than hedge funds as they invest in unlisted companies. Also, these funds have a lock-in period of 5-7 years. This is mainly because the company the fund invests in needs time to turn around and give results. Hence private equity funds are less liquid than hedge funds.
The expense ratio of a private equity fund is based on a hurdle rate. The fund will charge an incentive-based fee only after the hurdle rate is crossed. If the fund fails to achieve returns higher than the hurdle rate, then the private equity fund will not charge any incentive-based fee. Private equity falls under Category II AIFs, and the capital gains are taxable based on investors income tax slab rate.
Difference Between Private Equity Vs Hedge Fund
Following are the key differences between hedge fund vs private equity:
A private equity fund focuses on investing in companies that have the potential to offer substantial profits over a long term. They invest in private entities or acquire entities that are publicly listed on the exchange. Furthermore, a private equity firm acquires good equity stakes in companies by means of leveraged buyout (LBO). Then, PE funds take steps to improve the performance of the company by changing the management or streamlining the operations or expansions, etc. The main goal of the private equity funds is to sell their shares at a sizable profit. The average investment horizon is between five years to seven years.
On the other hand, hedge funds invest in funds that generate good ROI in the short term. Hedge fund managers usually prefer highly liquid assets so that they can enter and exit quickly. A hedge fund investment can be as short as a few seconds to a couple of years. The primary focus is on moving to the next promising investment.
Investments in a private equity fund is made as and when a private equity fund manager calls for it. Investors have to commit for a certain period of time in private equity investment. On the other hand, in hedge funds, investors have to make a one-time lump sum investment. There is no restriction in holding hedge funds, one may liquidate it any time.
Private equity funds are close-ended funds that have restrictions on transferability for a certain time period. On the other hand, hedge funds are open-ended actively managed funds that have no restrictions on transferability.
Private equity funds have a hurdle rate. Private equity firms charge investors 2% as management fees and 20% as an incentive fee. Also, private equity funds earn incentives only when the fund crosses the hurdle rate. For example, suppose the hurdle rate is 10%, and the annualised return is 8%. In that case, the PE firm doesn’t charge any incentive fee from the investors. On the other hand, if the annualised return is 12%, the incentive fee is charged on the full 12% of return.
In a hedge fund, the fees are based on the concept of a high watermark. Also, hedge funds follow the 2/20 rule. Where they charge a management fees between 1% to 2% and an incentive fee of 20%. The NAV for investors varies and depends on the time of their entry. For example, the NAV of a hedge fund at the time of investment is INR 1,000. During the year, if the NAV rises to INR 1,200, then the hedge fund will get an incentive of INR 200. If the NAV fell to INR 500 and rose back to INR 800, then the hedge fund will not be entitled to any incentive. This is because the high watermark of INR 1,000 was not broken.
Degree of Risk
Both private equity and hedge fund investments are volatile. In comparison to a hedge fund, private equity funds are less risky. On the other hand, hedge funds are high-risk investments, as they aim to generate significant returns in a short term.
Level of Participation
In private equity investments, the investors are active participants. While for hedge funds, investors are vested with passive status.
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Frequently Asked Questions
Hedge funds are investment vehicles that pool money from investors with similar investment objectives and invest them based on a strategy. The minimum investment in these alternative investment funds per investor is INR 1 crore. These are high-risk investments that invest in equities, debt securities, currencies, real estate etc. The hedge fund charges a management fee of 2% and also has a share in profits of around 15%-20%.
Private equity funds are alternative investment funds that invest in unlisted companies or in buyouts of public companies. They are closed-ended funds with a typical investment horizon of seven to ten years. They also have a lock-in of five to seven years. Private equity firms charge an incentive-based fee based on the hurdle rate.
Therefore, between the two investments, the choice depends on the individual’s investment horizon, financial status, understanding and willingness to undertake the risk. Also, the costs associated with these investment options are high. Hence, an investor has to evaluate all the parameters before investing.
In India, hedge funds have not picked up much when compared to other counties. However, in India, hedge funds have managed to give double-digit returns in the past. Hedge funds are high-risk investments; hence hedge fund investors need to absorb high risk for high returns.
Its mandate limits a Hedge fund’s investment universe. For example, a hedge fund can invest in equities, derivatives, currencies, real estate, and other alternative assets. They often follow event-driven, market neutral, long/ short selling, arbitrage and market-driven investment strategies. Also, all the investments are for a very short investment period. While, private equity funds are long term investment options, with an investment horizon ranging between five to seven years. Therefore, hedge funds do not invest in private equity.
Hedge funds are formed as Limited Liability Partnerships (LLP) or Private Companies, and these are privately held by the fund or portfolio manager or Registered Investment Advisors (RIA).