Hedge Funds Vs Private Equity : Difference & Investment Option

The Securities and Exchange Board of India (SEBI), through SEBI’s (Alternative Investment Funds) Regulations, 2012, regulates Alternative Investment Funds like Hedge Funds and Private Equity. These funds entail high-risk investments, that primarily invest in private companies and marketable securities. Although Hedge Fund and Private Equity funds are both alternative investments, they differ in terms of taxation, investment structure, horizon, and expense ratio. 

 

 

What are Hedge Funds?

 

A Hedge fund is a type of investment vehicle that pools money from multiple investors and makes a variety of investments in different kinds of assets. The portfolio construction and risk management techniques of hedge funds are complex. They are privately managed investment funds that invest in non-traditional assets and generate high returns. In India, they are classified as Alternative Investment Funds (AIF).

 

The fund manager seeks to maximize the return on investment for investors by investing in multiple assets using various investment strategies. For a fund to qualify as a hedge fund, it must have a minimum corpus of INR 20 crore and a minimum investment of INR 1 crore from each investor. 

 

Features Of Hedge Funds

 

• Minimum Investment: The minimum investment is INR 1 Crore. Usually, only High-Net-Worth Individuals (HNIs), banks, insurance companies, and pension funds can invest in hedge funds.

 

• Fee Structure: Both the management fee and expense ratio concepts are used in the workings of hedge funds. Generally, on an international level, it is “Two and Twenty,’ which means there is a 2% fixed fee and 20% of profits. As for hedge funds in India, the management fee is typically around 2%. In general, profit sharing ranges from 10% to 15%.

 

• Portfolio Management: The diversified portfolios of hedge funds include stocks, bonds, derivatives, private equity funds, currencies, and venture capital. It can invest in non-traditional asset classes and therefore has a portfolio that is diversified.

 

• Risks: They are susceptible to enormous losses. Despite their risk management, they are regarded as high-risk investments due to their aggressive nature. 

 

• Taxation: In India, hedge funds are heavily taxed. They fall under Category III of AIF, and the tax rate on annual earnings over INR 5 crores is 42.74 % for the investor.

 

• Absolute Return Products: There are no benchmarks against which hedge funds can compare their performance. Their performance is independent and measured in absolute terms.

 

• Regulations: It is not necessary for hedge funds to be registered with the securities market regulator, and they are not subject to any reporting requirements, including the regular disclosure of Net Asset Values (NAV).

 

Who Can Invest In Hedge Funds?

 

These are private investment pooled funds. Unlike mutual funds, it is not open to all investors. It is open to institutional investors, pension funds, banks, insurance companies, and High-Net-Worth Individuals (HNIs). Investors, such as banks, institutional investors, etc., have access to a substantial amount of capital, as well as research and capital management experts, along with portfolio managers.

 

It requires a minimum investment of INR 1 crore. They are expensive to invest in as well. They have a high expense ratio. It is also extremely risky as an investment vehicle. The tax on these funds is also quite high. It usually requires both risk tolerance and a complex strategy.

 

The hedge fund strategy is appropriate for wealthy investors who have excess capital to invest and a high-risk tolerance. Prior to making an investment, the investor must have faith in the fund manager. Before investing in it, investors must consider all of the above, along with risk and return factors.

 

How Do Hedge Funds Work?

 

Managers of hedge funds play a crucial role in generating returns. Usually, multiple managers are employed to manage the fund’s investments as part of the strategy. Before choosing an asset to invest in, these managers conduct extensive research and provide investors with personalized service. These are an alternative to traditional investments, so investors choose them to diversify their portfolios. Managers employ a variety of strategies to generate profitable returns. The following are a few strategies that are adopted by the managers:

 

• Global Macro Strategy: The fund managers utilize economic variables, evaluate their impact on the markets, and formulate investment strategies based on this information. Instead of relying on valuations, this strategy is based on upcoming movements. They use a variety of quantitative techniques to calculate the investment’s holding period, long-short positions, and short sell.

 

• Event-Driven: Managers of hedge funds make investments based on events such as mergers and acquisitions, shareholder buybacks, financial distress, tenders, and debt exchanges. Using fundamental analysis, they invest in equity and credit positions.

 

• Relative Value: Portfolio managers make investments based on arbitrage opportunities in equity, fixed income, or derivatives. They use fundamental and quantitative analysis to determine what kind of security to invest in when to invest in it, and for how long.

 

• Equity: The portfolio managers make equity investments. They take long or short positions or short sell the underlying security or derivatives of the security in order to capitalize on low valuations or capture corporate events.

 

• Multi-strategy Fund: Multiple fundamental and quantitative methods are implemented by hedge fund managers to make investment decisions. They may focus on a particular sector for equity holdings but may go long or short in other sectors to profit from a bull or bear market.

 

The Advantages Of Hedge Funds

 

• Diversification: Hedge funds are able to diversify investments because they offer a variety of investments. Long/short, tactical trading, event-driven, and emerging markets are just a few of the strategies. The sophisticated and complex strategies employed by the fund managers to manage the fund make it better than regular investments in terms of risk assessment. 

 

• Expert Advice: The managers of hedge funds are experts in financial management, in addition to having advanced knowledge of investment-related topics. Such a complex investment vehicle fund requires a great deal of experience and analytical ability to make an investment decision. 

 

• Personalized Portfolio: As the minimum investment amount is high, investors receive the best services and a personalized portfolio. A customized portfolio managed by a portfolio manager is one such service.

 

• Low Correlation: Investments in hedge funds are independent of the market index. Hence, they are less susceptible to market fluctuations.

 

• Aggressive Investment Strategies: When discussing hedge funds, aggressive investment is one aspect that stands out in particular. This is essential for achieving a higher return. These investment strategies also include short selling, leveraged buying (the use of borrowed funds to purchase additional assets), and derivatives.

 

What Is Private Equity?

 

When investors invest directly in private companies, these investments are referred to as Private Equity. They invest primarily in unlisted companies. They are a type of Alternative Investment Fund that falls under the AIF Category II. 

 

In India, private equity is governed by the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012. Private equity funds are alternative investment funds with a closed-end structure that do not accept new investments after the initial period has expired. 

 

Private equity investments typically have longer holding periods. This is primarily due to the fact that the company in which the fund invests needs time to generate results. Therefore, investors who are attracted to private equities are typically retail or institutional investors who can afford to invest large sums of capital for an extended period of time. This enormous capital is subsequently used by the company to finance expansions, purchase new technologies, strengthen its balance sheet, etc.

 

Who Invests In Private Equity?

 

Private equity investments frequently attract institutional investors and wealthy individuals. However, only investors with a high-risk tolerance and a high net worth should consider investing in private equity. Investors should be aware of the company’s past performance and managerial expertise before deciding to invest. Typically, the money is invested in new companies deemed to have substantial growth potential. Private equity firms seek to increase the value and profitability of the companies they acquire. For instance, they may bring in a new management team, cut costs aggressively, etc. 

 

Private Equity Investment Strategies

 

There are plenty of Private Equity (PE) investment strategies. A few of them are: 

 

• Venture Capital: The fund is used to invest in companies that are still in the early stages of development and don’t have access to conventional sources of financing or financial markets. It is inherently risky because startups, many of which are little more than ideas at the time of a pitch, have not yet demonstrated their profitability. As with any investment, the return on venture capital investments is never guaranteed. However, if a startup proves to be the next big thing, venture capitalists stand to make millions or even billions.

 

• Growth Capital: Growth capital is used to finance established private companies that lack the necessary assets. Due to a lack of necessary assets, these companies are unable to use conventional financing methods for expansion. Typically, growth equity investors demand a growth strategy from the company in order to accurately estimate the return on investment. For instance, a company seeking growth equity funds may need to hire new employees, rent office or retail space, or acquire new production technology in order to meet rising demand.

 

• Turnaround / Emergency Circumstances: When a company cannot recover its existing debt, it may turn to equity capital funding. The funds are used to stabilize the company’s balance sheet and to support management-led turnaround strategies.

 

The Advantages Of Investing In Private Equity

 

• Untapped Potential: By making investments in privately held, unlisted companies with significant growth potential, investors can earn great returns. 

 

• Significant amounts of funding: Due to the fact that PE funds are debt-free, they are an excellent source of financing. A new business can receive substantial startup funding from private equity.

 

The Difference Between Hedge Funds and Private Equity

 

Private equity and hedge funds differ in terms of their time-to-hold, liquidity, leverage, and strategic direction of investments, which in turn influence their exit strategy, risk tolerance, and desired rate of return.

 

• Horizon: A private equity fund is primarily concerned with investing in businesses that have the potential to generate substantial profits over the long term.  In addition, a private equity firm acquires substantial equity stakes in companies through Leveraged Buyouts (LBO). The primary objective of private equity funds is to sell their shares for a substantial profit. The typical investment horizon ranges from five to seven years.

 

Hedge funds, on the other hand, put money into investments that have a high short-term return on investment. Typically, hedge fund managers prefer highly liquid assets so they can enter and exit swiftly. 

 

• Structure: Private equity funds are closed-end funds with transferability restrictions for a specified time period. In contrast, hedge funds are open-ended actively managed funds with no transferability restrictions.

 

• Risk: Private equity investments and hedge fund investments are both volatile in nature. Private equity funds are significantly less risky than hedge funds. On the other hand, hedge funds are high-risk investments because they aim to generate high returns quickly.

 

• Participation: The investors are active participants in private equity investments. In contrast, hedge fund investors have a passive status.

 

What are Alternate Investment Funds (AIFs)?

 

Alternative Investment Funds (AIF) differ from traditional asset classes (investments) such as stocks, bonds, etc. An Alternative Investment Fund is a privately pooled investment vehicle that collects funds from sophisticated private investors.

 

AIFs consist of private equity, venture capital, hedge funds, angel funds, and so on.   Those who wish to diversify their portfolios can invest in Alternative Investment Funds. AIFs are open to investment by all Indians, including NRIs, PIOs, and OCIs. However, they must meet the eligibility criteria.

 

SEBI divides Alternative Investment Funds into three broad categories:

• Category 1 AIF
• Category 2 AIF
• Category 3 AIF

 

Frequently Asked Questions (FAQs)

 

• What are private equity funds?

Private equity funds invest in unlisted private companies in exchange for a share of their ownership. When unlisted companies cannot fund themselves through the issuance of equity or debt instruments, or through venture capitalists, they typically turn to private equity funds.

 

• Which is better Private Equity vs Hedge Fund?

Hedge funds pool capital from investors with similar investment objectives and invest it in accordance with a strategy. The minimum investment per investor in these Alternative Investment Funds is INR 1 crore. These are high-risk investments that include stocks, bonds, foreign exchange, real estate, etc. 

Private equity funds are alternative investment funds that make investments in unlisted companies or in buyouts of public companies. The typical investment horizon for these closed-end funds is seven to ten years.  

Therefore, the choice between the two investments depends on the individual’s investment horizon, financial situation, understanding, and risk tolerance. Furthermore, these investment options come at a high cost. Therefore, before investing, an investor must evaluate all the parameters.

 

• What is the minimum amount required to invest in a hedge fund?

A hedge fund is an Alternative Investment Fund (AIF), and the minimum investment from each investor must be INR 1 crore. And the minimum investment required to establish a hedge fund should be INR 20 crore.

 

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