By wallst
Both hedge funds and private equity funds are unregulated, generally private firms targetting high net worth and institutional investors. I will explain the traditional differences, but lately, both groups have been branching out into the other's territory.
Type of Investments
Private Equity funds generally make highly concentrated bets on the equity of a few companies. Although they had generally preferred to take complete control, in the bull market of 2006/2007 deals became so large that they were forced to do "club deals", partnering with other firms to find enough capital to get a deal done. Once they become owners of these portfolio companies, they generally work closely with management to improve operations in order to make the company more valuable. They will pay themselves dividends over time, as possible, but the real money is made when either the company is sold or IPOs.
Hedge funds, on the other hand, make a broader set of short-term investments. There are many strategies that are used (long/short equity, credit, macro, stat arb, etc) and trades can last from milliseconds to years. Many hedge funds prefer to stay in relatively liquid securities so that they can trade out at any point in time to lock in their profits.
Capital Structure
Because Private Equity funds make large investments, it can take them years to find a way to lock in their profits. Investors realize this and so are willing to provide money to these funds that is locked up for 5 years or longer. Hedge Funds, on the other hand, were thought to be able to provide liquidity to investors at any time. Practically speaking, investors had been able to put money in or pull money out once a month or quarter, depending on the fund. Unfortunately, the credit crisis of 2008 revealed all kinds of loopholes that allowed Hedge Funds to restrict people from getting their money back.
Fee Structures
Both types of funds are paid an annual management fee (between 1% and 3%) as well as a performance fee (between 10% and 30% of gains). The main difference is that hedge funds tend to take out their performance fees every quarter or every year, whereas private equity funds do not get paid until their investments are exited. This can mean that no performance fees are taken for 5 years or more.
Branching Out
In 2007, the big Private Equity firms all considered or started up hedge fund units, typically to get involved in the credit markets. This trend continued after the credit crunch as distressed securities of LBO'd companies became better investments than the equity ever was.
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