Double-digit annual returns? An introduction to private equity and hedge funds
Double-digit annual returns? Impossible? Not with private equity funds or hedge funds.
Until the 2008 market crash, many private equity funds and hedge funds enjoyed annual returns of 100% or more. Some of the highest flying funds made returns of 20% or 30% or more each month.
With the market down, double-digit monthly returns are nearly impossible, but double-digit annual returns are still common.
Private equity funds and hedge funds were relatively unregulated until the Bernie Madoff scandal and other less notorious scandals crashed the party. Following the 2008 crash, the SEC has enacted a series of regulations that have made hedge fund and private equity fund managers more accountable and their actions more transparent.
From the 1990s to the early 2000s, clear distinctions could be made between private equity funds and hedge funds, but in recent years these terms have become essentially interchangeable.
A hedge fund or private equity fund is a largely unregulated business partnership in which partners pool their capital in the hope of absolute returns. The main difference between a private equity fund and a hedge fund is their investment approach or strategy. Private equity funds invest only in private equity investments, while hedge funds can invest in any type of investment.
An absolute return is a measure of profit or loss expressed as a percentage of the total invested. A private equity investment is a private offering of securities or debt, not open to the public. Only “sophisticated investors” can invest in private offerings. A sophisticated investor is an investor who is believed to have the range and depth of investment knowledge and experience to weigh the risks and merits of an investment opportunity.
Both types of funds are structured as limited partnerships with the fund manager as the general partner.
The benefits and risks differ substantially from more common investments, such as public stock purchases, mutual funds, certificates of deposit, or annuities. Private equity funds and hedge funds present higher risk than more common investments because they seek absolute rather than relative returns. Because of this, the risk is also potentially higher, but the reward can also be many times higher.
Mutual funds and other traditional investments look for relative returns, which is a simple year-over-year return. The benefit of investing in a private equity fund or hedge fund is the potential to receive higher returns than other investments. The risk of these investments is the possibility of losing all your money due to mismanagement, market fluctuations or fraud as investors who trusted Bernie Madoff can attest. Because of these risks, private equity funds and hedge funds require investors to be sophisticated investors.
Participation in one of these funds is open to any person or company that meets the SEC’s definition of a “sophisticated investor.” A sophisticated investor must also be an “accredited investor,” which is anyone with a net worth of $1 million or more. Y a net income of at least $200,000 in each of the previous two years. Companies with assets of at least $5 million or a chairman, CEO or director of such a firm and other entities such as banks, sovereign wealth funds, endowments and pension funds would also qualify as accredited investors.
The fees associated with these funds can vary, but they generally fall into two types; a management fee and an incentive fee. A management fee, often 2%, is charged to the investor to participate in the fund. Incentive fees are performance-based fees, typically 20%, and are awarded to the management team based on the absolute performance generated by the fund.
Smaller funds are better. A smaller fund has clear advantages over a larger fund in that you have a larger number of investments to choose from (how many billion dollar investments are available?) and it is easier to achieve a higher level of return. A $1 billion fund would have to earn $100 million to achieve a 10% return, but a $100 million fund would have received a 100% return on the same investment.
There are more than 6,500 private equity and hedge funds. Some of the better-known funds include Mitt Romney’s alma mater, Bain Capital, as well as The Blackstone Group, Apollo Global Management, Warburg Pincus, Tiger Global, Davis Capital, and Kohlberg Kravis Roberts.
Private equity funds and hedge funds vary widely in their risk parameters, investment strategies, and entry requirements. It is recommended that you consult your financial advisor or legal advisor before any investment.
This article is provided for informational purposes only and is not intended to provide financial or legal advice of any kind. It also does not promote or disparage any fund or the private equity or hedge fund industry. Always consult a financial advisor and/or legal advisor before making any investment decision and never, ever invest more than you can afford to lose.