Hedge Funds vs Private Equity: Complementary Roles Within Investment Portfolios
There are several important investing strategies to understand when comparing hedge funds vs private equity funds.
KEY INVESTING STRATEGIES
Hedge funds are alternative investment pooled vehicles that are actively managed and utilize different strategies to earn idiosyncratic (non-market, directionally-related) and thus skill-based returns—or alpha—for their investors. Hedge funds typically invest in the public markets (stocks, bonds, currencies, derivatives and interest rates). Some hedge funds also invest in private markets—like their private equity peers—but to a lesser extent. The dynamic, skill-based and idiosyncratic source of hedge fund returns generally results in hedge funds having a lower correlation to the public markets than mutual funds or ETFs.
Arbitrage Funds – These funds seek to arbitrage the pricing discrepancies that exist due to market imperfections. The arbitrage category includes some of the following strategies: convertible bond arbitrage, tail protection, volatility trading, capital structure arbitrage, and ETF or structured retail product arbitrage (e.g., monetizing pricing patterns derived from ETF or mutual fund index rebalancing). Investing to capitalize on short-term price relationship distortions and trends typically results in arbitrage funds having low to almost no correlation with public markets.
Credit – Credit strategies look to generate risk-adjusted returns using various credit instruments such as credit securities, asset-backed loans, collateralized loan obligations and collateralized debt obligations. The strategy is typically expressed with a net long bias due to the costs of negative carry when shorting a fixed income instrument. In other words, when you short a bond, you are betting against the entire return profile of the bond, including the coupon. While not heavily trading-oriented (given the associated costs), the strategy is more event-focused than passive and, as such, tends to have shorter investment horizons when compared to the distressed debt category. Returns are generated from a blend of coupon income and capital appreciation due to spread tightening (or widening on shorts). Given that this strategy is long biased, credit funds tend to have a higher long-term correlation to the public markets than many of its hedge fund peer strategies.
Distressed Funds – This strategy typically invests in non-investment grade corporate (and sometimes sovereign) debt, which is frequently stressed (e.g., performing, but priced at a significant discount to par) or defaulted. Accordingly, the borrower is no longer making payments to its bondholders and lenders. Some funds invest in deeply discounted and/or subordinate structured product. The time horizon for these strategies is typically longer dated, as it may take lengthy bankruptcy proceedings to maximize gains and crystalize the investments, especially when the fund has taken a controlling debt position. Stressed and distressed resolution outcomes are not necessarily tied to the movements of the broader markets, which can lead to distressed debt funds having a lower correlation to the public markets over the long term.
Event-Driven – The event-driven category covers funds that maintain positions in companies facing announced or anticipated corporate events, including but not limited to: M&A, spin-offs, company restructurings, and some distressed situations. Funds that are categorized as event-driven include activist, merger arbitrage, opportunistic, and event-driven multi-strategy. The strategy identifies mispriced securities with favorable risk/reward characteristics based upon differentiated views of value-unlocking catalysts, event-probabilities, and post-event valuations. Many event-driven hedge funds attempt to isolate the event catalyst by hedging away the underlying securities’ beta, and thereby exposing the fund only to the identified event and not to market direction. As a result, event-driven managers tend to have low correlation to the public markets.
*Long/short Funds - This strategy invests in equities, both on the long and short side. These funds may vary by market and sector exposures, target gross and net exposures (how long or short), and other factors. Traditionally long/short equity funds have had a fundamental bias and managed on a discretionary basis where value and/or growth-oriented investment theses are typically adopted. However, there has been a recent trend of long/short equity funds that invest based on a quantitative, systematic and technical approach.
*Macro Funds – Macro funds traditionally take positions (either directional or relative-value) in currencies, bonds, equities, and commodities based on fundamental and qualitative judgements. Investment decisions can be based on a manager’s top-down views of the world (e.g., views on economy, interest rates, inflation, government policy and/or geopolitical factors). Relative valuations of financial instruments within or between asset classes can also play a role (or be the dominant part) in the investment process. Primary areas of focus are the liquid instruments of G10 countries, although some funds may also include emerging markets. However, similar to the long/short equity bucket, there is a new trend of blended discretionary and systematic—or purely systematic—macro funds that follow a rules-based and algorithmic quantitative approach to the macro markets. Macro funds are focused on central bank action and trends that include the ever-changing, interconnected nature of various asset classes, which typically produces a low correlation fund return stream to the traditional markets.
Market Neutral – These funds, which can include factor-based and statistical arbitrage strategies, employ sophisticated quantitative techniques to ascertain information about future price movement and relationships between securities. To classify as “equity market neutral”, funds are expected to run with a very tight net exposure, meaning very low long or short aggregate net positioning via the use of leverage, which should be close to zero over the long term. The distinguishing characteristic is that market neutral funds run with low net market exposure at all times. Market neutral funds can be classified further based on other factors, including sector exposure, markets they trade, or differences in risk parameters. Historically, these funds tend to be built upon a fundamental approach to stocks, but a growing subset of managers employ a blended or purely systematic quantitative equity market neutral strategy. Generally, the very low net market exposure of equity market neutral funds tends to lead to the strategy providing close to zero correlation to the publicly traded markets.
* Multi-Strategy – The investment objective of multi-strategy hedge funds is to deliver consistently positive returns regardless of the direction of the public markets. Multi-strategy hedge funds typically allocate capital across multiple sub-strategies and asset classes. Funds are typically extremely diversified and employ multiple PMs/risk takers. The diversified nature of multi-strategy funds typically results in a modest correlation to the public markets.
*Multi-strategy, long/short, and macro funds are among the top three performing strategies for 2020. Learn how the institutional hedge funds on our platform have performed YTD compared to their corresponding hedge fund strategy index.View Hedge Funds ≫
Private equity funds are investment vehicles that invest capital into private companies. Occasionally, a Private Equity Fund invests in a public company with the objective of taking it private in the near term. The private markets play a significant role in global GDP. In the US, 98% of companies with sales over $10M are private and not listed or traded on public exchanges. Furthermore, companies are waiting to go public later in their maturity from both an age and revenue perspective, implying that much of the globe’s economic growth occurs in a private format.
Buyout – This strategy invests in mature but often underperforming private companies with proven business models and steady cash flows that can be improved through operational, financial, governmental and other factors brought to bear by experienced fund managers. Companies are exited once the manager has completed their underwritten improvements to the company.
Leveraged buyouts borrow a large amount of capital – through bonds and loans – to acquire a company. The idea of a leveraged buyout is to make enough returns on the acquisition to offset the interest cost.
Distressed - Funds that invest in troubled companies’ debt or equity to take control of the companies during bankruptcy or restructuring processes, turn the companies around, then eventually sell them or take them public.
Growth Equity – Growth equity (or growth capital) is designed to facilitate the target company’s accelerated growth through expanding operations, entering new markets, or consummating strategic acquisitions. The risk shifts from whether a product will gain market adoption to whether it can be sold profitably. These are companies that are less mature or stable than the type of company that buy-out strategies focus on.
Venture Capital – Venture capital consists of investments in new products and services where the objective is to achieve outsized returns from investing in the next must-have technology, breakthrough drug discovery or massive consumer trend. VC firms will provide funding in exchange for a minority stake of equity—less than 50% ownership—in these businesses.
Private Credit – These funds target the ownership of higher-yielding corporate, physical (excluding real estate), or financial assets held within a private “lock-up” fund partnership structure. These funds typically have the objective of producing an attractive net distributable income or yield as compared to what is available in the public fixed income markets.
TYPES OF INVESTORS
Qualified institutional investors, endowments & foundations and qualified purchasers are a significant part of the investor base for both private equity and hedge funds.
Ivy League endowments have been a step ahead, with an ~40% allocation to institutional alternative investments, including hedge funds, private equity and real estate. Yale, in fact, has an 89% allocation to alternatives, with the lowest current allocation in their history to stocks and bonds. As of June 30, 2020, Harvard's endowment has 60% of the portfolio allocated to private equity and hedge funds and 40% to equities with modest real estate and fixed income exposure.
According to Preqin, interest in the alternative investment space is rapidly growing with an expectation to grow 59% by 2023, reaching $14 trillion in assets. As the sector itself is continuously evolving, investors seeking new opportunities are starting to migrate towards the asset class.
HEDGE FUNDS VS PRIVATE EQUITY FUNDS: COMPLEMENTARY ROLES WITHIN INVESTMENT PORTFOLIOS
Alternative investments may offer investors a much-needed source of portfolio diversification, reduced risk, and better risk-adjusted returns in comparison to that of traditional investments. Hedge funds and private equity provide distinctly different risk/return and liquidity profiles within an investor’s broader portfolios as follows:
Low Correlation to Equities & Bonds / Diversification - Given that hedge funds trade in liquid markets and provide for moderate liquidity, they are typically included as a complement to an investor’s traditional portfolio of stocks and bonds. Due to a variety of factors, including the dynamic nature of hedge funds’ absolute return strategies, the performance of hedge funds tends to be less correlated to traditional investments. Especially in declining markets, they offer a unique source of diversification and volatility dampening that may enhance traditional investment portfolios.
Reduced Volatility = Increased Returns Over Time - A diversified portfolio of skill-based hedge funds can assist in achieving lower volatility within an investment portfolio, and therefore increases total returns over time. After all, volatility diminishes the rate at which investments grow over the long term and has a negative impact on portfolio returns.
Chance for Greater Gains - One reason for increased investor interest in private equity investments is the return enhancement potential.
Due to the influx of capital to the private equity space, companies are increasingly staying private longer. As a result, once a company reaches the point of going public, they are more mature with less future growth potential. Imagine being able to buy into Apple or Microsoft before these companies went public! This is an example of the kind of growth that some private equity investors might see if they invest in institutional private equity funds.
Additionally, there are certain advantages for more mature companies to choose buy-out funds as their source of capitalization vs public funding. This includes the ability to implement a longer-term business plan to optimize the profitability of an established business in lieu of being subjected to the impatient quarterly earnings calendar in the public realm. Skilled buyout managers establish long term strategies that may negatively impact revenues and EBITDA in the short term, with the longer-term goal of creating a much more profitable enterprise over the next few years.
Downside Risk Protection - An often-overlooked benefit of private equity is that it can improve risk management.
The addition of private equity investments within a traditional investment tends to lower the portfolio’s volatility, assisting in risk management.
Private equity investments are less affected by immediate economic and market-based trends. The value of private equity investments is tied to company metrics and performance and the operational expertise of PE fund management. They are not as influenced by swings in the market as traditional investments are.
During recessions, two-fifths of publicly listed equities have experienced “catastrophic loss,” defined as a 70% or greater drop from their peak values. Yet fewer than 3 out of 100 private equity funds have suffered a similar loss.
Potential to Generate Income - Laddered consistently and periodically (vintage diversification), a systematically designed private equity portfolio should produce a staggered series of consistent cash flows and liquidity events for an investor. Cash flows can be accelerated with the inclusion of private credit and real assets.
FUND STRUCTURE AND TERMS
The fund structure is quite different when comparing hedge funds vs private equity funds.
Hedge funds are what are known as “evergreen” investment structures. Limited partners/investors in a hedge fund can subscribe monthly to a hedge fund, and that entire subscription is invested in the first of the month. Depending on a hedge fund’s strategy and underlying asset mix, there are various liquidity terms that may restrict how soon and how much an investor can withdraw their investment at any given time.
For example, because of the global, diversified and highly liquid nature of a macro hedge fund’s portfolio, some funds will offer monthly or quarterly liquidity with no investor level gates, meaning an investor can get the majority of their investment back on a monthly or quarterly basis. On the other hand, a distressed credit fund, due to the semi or illiquid nature of the underlying assets that the fund owns, may only allow investors to access their investment on an annual or semi-annual basis, but with an investor level gate (e.g., 1/8th of an investor’s investment per quarter).
For private equity funds, the investor commits the capital they wish to invest. The fund will then call the committed capital periodically over the investment period of the fund (typically 5 years) as the fund manager finds attractive investment opportunities. Investments are then typically held for 5 to 7 years before they are sold, which is commonly referred to as the Harvest period of the Private Equity Fund.
Once an investment is sold, the capital is returned to the investors. As a result, investors who want to maintain their allocation to private equity must continuously commit capital to new funds through time. When private equity fund managers invest 70% of capital commitments, they will start raising their next fund so that they always have capital to invest.
THE DIVERSIFED PORTFOLIO MENTALITY
Alternative investments do not act in isolation. With over 25 years of alternative investment experience, we utilize our expertise and deep network to provide exposure to third-party institutional private equity and hedge funds across a variety of strategies, geographies, industries, and vintage years - with low investment minimums.
Our manager selection process is conflict-free, as we are not compensated by any of the managers in the program. We seek to identify those with a proven track record, a dedicated risk management process, deep teams, and institutional safeguards.
Successful alternative investing requires skillful execution. We help advisors build diversified private equity and hedge fund portfolios of institutional funds, coupled with quantitative analytics, qualitative research, a streamlined workflow and ongoing monitoring and rebalancing support.