6.5 Hedge Funds & Private Equity

Hedge funds and private equity are alternative investments typically available only to wealthy, sophisticated investors. Understanding their characteristics, strategies, and risks is important for investment advisers.

Hedge Fund Overview

Hedge funds are privately offered pooled investment vehicles that use sophisticated strategies to generate returns.

Characteristics

Registration: Hedge Funds - Limited (private placement); Mutual Funds - SEC registered

Investors: Hedge Funds - Accredited/qualified only; Mutual Funds - Anyone

Strategies: Hedge Funds - Flexible; any strategy; Mutual Funds - Investment policy restrictions

Leverage: Hedge Funds - Extensive use; Mutual Funds - Limited

Short Selling: Hedge Funds - Common; Mutual Funds - Limited

Liquidity: Hedge Funds - Lock-up periods; Mutual Funds - Daily redemption

Transparency: Hedge Funds - Limited disclosure; Mutual Funds - Full disclosure

Fees: Hedge Funds - "2 and 20" + expenses; Mutual Funds - Expense ratio only

Legal Structure

Hedge funds typically avoid Investment Company Act registration through exemptions:

3(c)(1) Funds: Maximum 100 investors (or 250 for funds less than $10M)

3(c)(7) Funds: Unlimited qualified purchasers

Hedge Fund Fee Structure: "2 and 20"

The traditional hedge fund fee structure includes both management and performance fees.

Components

Management Fee: Typical Amount 2% annually. Description: Charged on total assets under management

Performance Fee: Typical Amount 20% of profits. Description: Also called "incentive fee" or "carried interest"

Example Calculation

Fund size: $100 million

Annual return: 15% ($15 million profit)

Management Fee: $100M x 2% = $2,000,000

Performance Fee: $15M x 20% = $3,000,000

Total Fees: $5,000,000

Net to Investors: $15M - $5M = $10,000,000

High-Water Mark

Many hedge funds use a high-water mark provision:

- Performance fees only charged on new profits

- If fund loses money, must recover losses before earning performance fees

- Protects investors from paying incentive fees after losses

In Practice: If a hedge fund declines 20% one year, then gains 15% the next year, the high-water mark means no performance fee in year 2 (fund hasn't exceeded its previous high). The fund must first recover to the high-water mark before charging incentive fees again.

Common Hedge Fund Strategies

Directional Strategies

Long/Short Equity: Buy undervalued stocks, short overvalued. Risk Level: Moderate

Global Macro: Trade based on macroeconomic views. Risk Level: High

Managed Futures: Trade commodity and financial futures. Risk Level: High

Emerging Markets: Focus on developing economies. Risk Level: High

Market Neutral Strategies

Equity Market Neutral: Equal long and short positions. Goal: Eliminate market risk

Statistical Arbitrage: Quantitative models find pricing inefficiencies. Goal: Low market correlation

Convertible Arbitrage: Long convertible bonds, short stock. Goal: Exploit mispricing

Event-Driven Strategies

Merger Arbitrage: Profit from announced M&A deals. Catalyst: Deal completion

Distressed Securities: Invest in bankrupt/troubled companies. Catalyst: Restructuring

Activist Investing: Take positions to influence management. Catalyst: Corporate changes

Hedge Fund Risks

Leverage Risk: Borrowing magnifies losses

Liquidity Risk: Lock-up periods prevent redemption

Manager Risk: Heavy dependence on manager skill

Transparency Risk: Limited disclosure of positions

Counterparty Risk: Risk of trading partners defaulting

Strategy Risk: Complex strategies can fail

Operational Risk: Small firms may have weak controls

Lock-Up Periods

Hedge funds typically restrict redemptions:

- Initial lock-up: 1-2 years before any redemption

- Redemption frequency: Quarterly or annually

- Notice period: 30-90 days advance notice

- Gates: Limit on percentage that can be redeemed

Private Equity

Private equity involves investing directly in private companies or taking public companies private.

Types of Private Equity

Venture Capital: Stage - Early stage. Strategy - Fund startups. Time Horizon: 7-10 years

Growth Equity: Stage - Expansion. Strategy - Minority stakes. Time Horizon: 5-7 years

Buyout (LBO): Stage - Mature. Strategy - Acquire companies. Time Horizon: 4-7 years

Distressed: Stage - Troubled. Strategy - Restructure companies. Time Horizon: 3-5 years

Venture Capital

Investment Stage: Seed, Series A, B, C funding

Target Companies: Startups with high growth potential

Risk: Very high; most investments fail

Return Profile: "Home run" returns from winners

Involvement: Board seats, strategic guidance

Leveraged Buyouts (LBOs)

Strategy: Acquire company using mostly debt

Target: Mature companies with stable cash flows

Debt Levels: 60-80% debt financing typical

Value Creation: Operational improvements, cost cutting

Exit: IPO or sale to strategic buyer

Private Equity Structure

Fund Structure

Private equity funds typically structured as limited partnerships:

General Partner (GP): Manages fund; makes investment decisions

Limited Partners (LPs): Investors; provide capital

Capital Calls

Unlike mutual funds, PE investors don't invest all capital upfront:

1. LPs commit capital (e.g., $10 million)

2. GP calls capital as investments are made

3. Capital called over 3-5 years

4. Called capital is invested in portfolio companies

5. Returns distributed as investments are exited

The J-Curve

Private equity returns typically follow a "J-curve" pattern:

Investment Period: Years 1-4. Returns: Negative. Reason: Fees paid, no exits yet

Harvest Period: Years 5-10. Returns: Positive. Reason: Successful exits begin

Final Years: Years 10+. Returns: Declining. Reason: Remaining investments exited

Investor Requirements

Accredited Investor

To invest in most hedge funds and private placements:

Income Test: $200K+ individual ($300K+ joint) for 2 years

Net Worth Test: $1M+ excluding primary residence

Professional Credentials: Series 7, 65, or 82 license holders in good standing

Qualified Purchaser

Required for 3(c)(7) funds with fewer restrictions:

Individual: $5M+ in investments

Family Office: $5M+ in investments

Institution: $25M+ in investments

On the Exam: Accredited investors qualify based on income ($200K/$300K), net worth ($1M), or professional credentials (Series 65 in good standing). Qualified purchasers have higher thresholds ($5M in investments) and can invest in funds with fewer investor limits.

Fund of Funds

A fund of funds invests in multiple hedge funds or private equity funds rather than directly in securities.

Advantages

Diversification: Exposure to multiple managers/strategies

Access: Entry to funds with high minimums

Due Diligence: Professional manager selection

Lower Minimums: More accessible entry point

Disadvantages

Double Layer of Fees: Pay both FoF fees and underlying fund fees

Over-Diversification: May dilute best ideas

Complexity: Less transparency into holdings

Key Takeaways

- Hedge funds charge "2 and 20" (2% management fee + 20% performance fee)

- High-water mark protects investors from paying incentive fees after losses

- Hedge fund strategies include long/short, global macro, event-driven, and market neutral

- Lock-up periods restrict redemptions; investors face illiquidity risk

- Private equity includes venture capital (early stage) and buyouts (mature companies)

- PE uses capital calls over time rather than lump-sum investment

- Accredited investor: $200K income, $1M net worth, or Series 65 holder

- Qualified purchaser: $5M in investments (higher threshold than accredited)