Hedge funds and private equity have one big thing in common. Both charge substantial fees typically 2 per cent of assets under management (AUM) and 20 per cent of investment profits. Otherwise, the differences are huge, The Financial Times reports.
Private equity is a heavily geared, “long-only” investment in illiquid assets, with high levels of control and a multi-year time horizon. Hedge funds, by contrast, typically invest in liquid securities, with no control.
So which of the two asset classes is more valuable when a management company goes public? The obvious answer is private equity.
First, assets are tied up long-term which provides flexibility to ride out tough times and a steady stream of cash from the 2 per cent management fee alongside the bigger and more volatile 20 per cent share of investment gains. By contrast, hedge fund investors can pull their money quickly if performance is bad, making the underlying fee stream less secure.
Second, private equity firms have established brands such as Blackstone and KKR, they buy full control of businesses people know, and buy-outs have largely avoided financial trouble in recent years.
Finally, private equity firms have a “cookie jar” of unrealised gains on their illiquid investments that should emerge as cash flow when the businesses are sold. Hedge funds are more geared to good performance. If they generate strong returns they enjoy handsome performance fees. The assets on which they can charge future fees also grow by that amount and the good performance attracts further inflows.
Private equity groups have longer to prove themselves, have real control over their portfolio companies and can ride out most market storms. Hedge fund investors, meanwhile, can see the real performance each month because most securities are listed. If that is bad, it can spark a rush to the exit and cause real problems for the management company.
However, the easy credit conditions that have fuelled the private equity boom are showing signs of strain and stocks are well into a long bull market. The flexibility of hedge funds to go short and mix up the assets they invest in might make the most blue chip managers look attractive in tougher times.