Hedge Fund vs. Private Equity Fund: What's the Difference?

Although their investor profiles are often similar, there are significant differences between the aims and types of investments sought by hedge funds and private equity funds.

Both hedge funds and private equity funds appeal to high-net-worth individuals (many require minimum investments of $250,000 or more), traditionally are structured as limited partnerships, and involve paying the managing partners basic management fees plus a percentage of profits.

Hedge funds are alternative investments that use pooled funds and employ a variety of strategies to earn returns for their investors. The aim of a hedge fund is to provide the highest investment returns possible as quickly as possible. To achieve this goal, hedge fund investments are primarily in highly liquid assets, enabling the fund to take profits quickly on one investment and then shift funds into another investment that is more immediately promising. Hedge funds tend to use leverage, or borrowed money, to increase their returns. But such strategies are risky—highly leveraged firms were hit hard during the 2008 financial crisis.

Hedge funds invest in virtually anything and everything—individual stocks (including short selling and options), bonds, commodity futures, currencies, arbitrage, derivatives—whatever the fund manager sees as offering high potential returns in a short period of time. The focus of hedge funds is on maximum short-term profits.

Hedge funds are rarely accessible to the majority of investors; instead, hedge funds are geared toward accredited investors, as they need less SEC regulation than other funds. An accredited investor is a person or a business entity who is allowed to deal in securities that may not be registered with financial authorities. Hedge funds are also notoriously less regulated than mutual funds and other investment vehicles.

In terms of costs, hedge funds are pricier to invest in than mutual funds or other investment vehicles. Instead of charging an expense ratio only, hedge funds charge both an expense ratio and a performance fee.

Private equity funds more closely resemble venture capital firms in that they invest directly in companies, primarily by purchasing private companies, although they sometimes seek to acquire controlling interest in publicly traded companies through stock purchases. They frequently use leveraged buyouts to acquire financially distressed companies.

Unlike hedge funds focused on short-term profits, private equity funds are focused on the long-term potential of the portfolio of companies they hold an interest in or acquire.

[Important: Once they acquire or control interest in a company, private equity funds look to improve the company through management changes, streamlining operations, or expansion, with the eventual goal of selling the company for a profit, either privately or through an initial public offering in a stock market.]

To achieve their aims, private equity funds usually have, in addition to the fund manager, a group of corporate experts who can be assigned to manage the acquired companies. The very nature of their investments requires their more long-term focus, looking for profits on investments to mature in a few years rather having the short-term quick profit focus of hedge funds.

Since hedge funds are focused on primarily liquid assets, investors can usually cash out their investments in the fund at any time. In contrast, the long-term focus of private equity funds usually dictates a requirement that investors commit their funds for a minimum period of time, usually at least three to five years, and often from seven to 10 years.

There is also a substantial difference in risk level between hedge funds and private equity funds. While both practice risk management by combining higher-risk investments with safer investments, the focus of hedge funds on achieving maximum short-term profits necessarily involves accepting a higher level of risk.

There are hedge funds that fit the classic definition—funds designed to provide protection of capital invested in traditional investments—but that is no longer considered the common usage of the term.

• Hedge funds and private equity funds appeal to high-net-worth individuals.
• Both types of funds involve paying managing partners basic fees plus a percentage of profits.
• Hedge funds are alternative investments that use pooled money and a variety of tactics to earn returns for their investors.
• Private equity funds invest directly in companies, by either purchasing private firms or buying a controlling interest in publicly traded companies.