“Private equity and hedge funds are alike in that they both take advantage of section 3 (c)(1) and 3 (c) (7) of the Securities Exchange Commissions’ 1940 act when they set up their structures,” says Raj Gupta, Research Director at University of Massachusetts’s Center for International Securities and Derivatives (CISDM), Isenberg School of Management in Amherst, MA. Another similarity is the trend among both to eventually go public, as seen in recent moves by private equity giants Apollo and the Blackstone Group, as well as hedge mega funds Fortress, Citadel, and Perry.
Where the Definitions Get Blurred
So how are these asset classes distinct? “One primary difference is that hedge funds concentrate on publicly traded securities, while private equity, when it jumps into publicly traded securities, does so to take the company private, often with loads of debt,” says Shantaram Hegde, professor of finance at the University of Connecticut in Storrs, CT. “Private equity managers work on restructuring the company to squeeze out more value over time. It’s a long-term investment, relatively speaking, whereas hedge funds are in and out of a position in three to six months, depending on market conditions. Private equity investors are business and operational managers, not just money managers” Hedge funds also limit their portfolio holdings to 15 or 20 securities, while private equity firms have a much smaller number of holdings, though individual investments are much larger.
Hegde believes that where the boundary between private equity and hedge funds gets blurred is in value creation, although in reality both rely on different strategies and tactics. Thus, private equity takes long-only positions, and tends to focus on venture capital types of investments and buyouts of distressed firms or poorly performing firms. Hedge funds, meanwhile, engage primarily in long/short strategies, and tend toward benchmark-driven portfolios of publicly traded securities or commodities.
Ultimately, value creation boils down to putting in the right incentives for fund managers. Fee structures for both fund types are performance based, and require on average two percent of the assets to cover management overheads, and a 20 percent performance fee (known as “2/20” structures). Private equity managers typically invest a higher stake of their wealth in a firm so there is more of an incentive to see the company succeed.
Where the Strategies Collide
At times, strategies for private equity firms and hedge firms intersect, but at cross purposes to each other. Thus, when a private equity firm buys out a distressed company, the managers will try to minimize the buyout price. The hedge fund manager, however, who is engaging in arbitrage while the company is still public, will try to hold out for higher takeover premiums. Debt is likewise two sides of the same coin: when private equity puts too much debt into firms they take private, hedge funds play the role of active shareholders, and seek to temper the debt burden.
In this scenario, what happens when one pension fund is a client of a private equity fund trying to buy a company for a discount, but also a client of a hedge fund or long-only manager that owns that very company? The latter wants to sell for the highest price in order to maximize returns on their investment, while the former also wants to maximize returns by buying cheaply? According to Hegde, there’s no clear-cut answer. “In this trade, the overall gain or loss for the pension fund depends on many variables,” he says. “These include portfolio diversification, relative bargaining power of the private equity firm and the hedge fund, and the pension’s asset allocation to both asset classes.”
Despite the lingering confusion, not all pension funds blur the lines between the two asset classes. Evelyn Tatkovski, Press Secretary, Pennsylvania Public School Employees' Retirement System in Harrisburg, notes that her fund makes very clear distinctions “We view hedge funds as privately organized, pooled investment vehicles investing in primarily publicly traded securities and derivatives that use leverage to magnify their alpha opportunities,” she says. “We view hedge funds as generally having limited transparency and limited liquidity as well. We don't include private equity in that definition.”