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Hedge Funds vs. Private Equity—What’s the Better Option?

Hedge Funds vs. Private Equity—What’s the Better Option?

During recessions, when inflation is high and stocks are underperforming, it’s hard to know where to put your money. At such times, more and more people turn to alternative investments– strategies that focus on unconventional or private assets and that may be able to avoid the effects of a bear market. 

Historically, alternative investments have had financial barriers to entry that are prohibitive for most retail investors. Now, though, it’s becoming easier for retail investors to access alternative investments.

In this article we’ll discuss the pros and cons of two of the most popular alternative investments– hedge funds and private equity.

Understanding Hedge Funds

Hedge funds are pooled investments managed by hedge fund managers—people who have a high degree of freedom in what they choose to invest in (as long as it’s aligned with their manifesto). This freedom sets hedge fund managers apart from traditional financial advisors—and can make hedge funds more high-risk/high-reward than most options available to retail investors.

Hedge fund managers invest in funds according to a specific (and sometimes extremely niche) strategy that their investors believe will work. The manager’s profits depend on the success of the fund; a common arrangement is “two and twenty,” meaning that the manager receives 2% of the invested assets up-front as a management fee and is also entitled to 20% of the gains they make with the fund.

Hedge funds are considered relatively illiquid because investors are often required to keep their money invested in the fund for at least one year.

While hedge funds typically only admit investors who meet high net worth requirements– commonly $5MM or $10MM—some funds, like COWAN WEALTH MANAGEMENT’s, allow multiple investors to join together to meet the requirement, thereby lowering it for each individual. Think of it as a pooled investment within a pooled investment.

Understanding Private Equity

Private equity, another form of pooled alternative investment, is often grouped with venture capital and hedge funds, but there are key differences between all three strategies.

Like venture capital, private equity is concerned with the purchase, management, and eventual sale of private companies. That means that—unlike hedge funds—private equity is not concerned with companies that are already listed on the stock exchange.

Unlike venture capital, which focuses on startups with growth potential and a high failure rate, private equity tends to gravitate towards mature private companies—those that have possibly established themselves in their industry. These firms may have brand recognition, and their growth rate has (typically) already leveled off by the time that private equity gets involved. Private equity is thus usually a more low-risk/low-reward option when compared to venture capital.

Private equity firms usually receive a discounted rate off the planned IPO price when they purchase a stake in a private company. This discount comes in exchange for the security the private company gets from a cash infusion in the event that the IPO performs poorly. It’s ultimately a risk (like everything else in investing).

Private equity funds are managed by a GP, or general partner, which is usually the private equity firm itself. Like hedge funds, many private equity forms receive 2% of invested assets as a management fee and are entitled to 20% of gains.  

This form of investment is considered illiquid, as private equity firms operate on long time horizons and usually prohibit investors from withdrawing their investment for multiple years. As with hedge funds, private equity usually only admits either corporate investors or individuals with a high net worth.

Private equity has expanded rapidly in recent years, with buyouts doubling from 2020 to reach $1.1 trillion in 2021 alone.