Private equity vs hedge funds: Here's what you need to know

Both private equity funds and hedge funds are restricted to accredited investors

Chitra Kadam August 21, 2022 10:43:04 IST
Private equity vs hedge funds: Here's what you need to know

Representational image. News18

Private equity (PE) is a form of financing where money, or capital, is invested into a company. Private equity is an alternative asset class alongside real estate, venture capital, distressed securities and more.

Alternative asset classes are considered less traditional equity investments, which means they are not as easily accessed as stocks and bonds in the public markets.

PE funds vs Hedge funds

Both private equity funds and hedge funds are restricted to accredited investors. However, the biggest differences between PE funds and hedge funds are fund structure and investment targets. Hedge funds tend to operate in the public markets, investing in publicly-traded companies while PE funds focus on private companies.

The economics behind

A hedge fund's purpose is to maximise investor returns and eliminate risk. If this structure and these objectives sound a lot like those of mutual funds, they are, but that's where the similarities end. Hedge funds are generally considered to be more aggressive, risky, and exclusive than mutual funds. In a hedge fund, limited partners contribute funding for the assets while the general partner manages the fund according to its strategy.

Because they expect to make money whether the market trends up or down, hedge fund management teams more closely resemble traders than classic investors. Some mutual funds employ these techniques more than others, and not all mutual funds engage in actual hedging.

Achieving true diversification

  1. Despite unique risks and considerations, alternative investments can be useful tools to improve the risk-return characteristics of an investment portfolio.

 

  1. They can increase diversification and reduce volatility, given low correlations to more traditional investments, and they can offer the potential for enhanced returns due to the wider investment opportunity .

The graph below illustrates a sample Markowitz efficient frontier, representing all portfolios with the lowest risk (as measured by volatility) for a given level of return, or conversely all portfolios with the highest return for a given level of risk.

Private equity vs hedge funds Heres what you need to know

The inclusion of alternative investments can move the efficient frontier up and to the left, so for a given level of return, risk is lower, or for a given level of risk, return is higher.

Benefits to investors

  • Investment strategies that can generate positive returns in both rising and falling equity and bond markets.
  • Portfolio diversification to achieve greater risk-adjusted returns.
  • Access to some of the world's most exotic asset classes

India: A growing hub for alternative investments

In terms of assets under management (AUM), AIFs in India are at the same stage that mutual funds were at, in 2009. The market and the industry is now geared towards a paradigm shift towards alternative investment funds.

The Indian alternatives industry has grown at a rapid pace of over 30 per cent CAGR over the last 4-5 years, making it one of the fastest growing markets for alternative assets globally. During the initial years, India was primarily a market for growth investments with funds restricting their exposure to minority stakes and smaller ticket size investments.

However, over the past 4-5 years there has been a change in the investment mix as the value and number of buyout deals have increased significantly, which in turn has led to deals becoming larger and more complex.

According to experts, “traditional investment pools are increasingly getting fragmented and facing challenges in product innovations, differentiation, and alpha generation owing to size and other factors.” And this is where AIFs are offering novelty in terms of product differentiation.

The author is Financial Engineer, Hedonova, an AIF firm. Views are personal.

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