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Double Digits 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 market crash of 2008, many private equity funds and hedge funds enjoyed annual gains of 100% or more. Some of the highest flying funds realized returns of 20% or 30% or more each month.

With the market crash, monthly returns in the double digits are nearly impossible but annual double digit returns remain commonplace.

Private Equity funds and hedge funds were relatively unregulated until the Bernie Madoff scandal and other less notorious scandals spoiled the party. Following the crash of 2008, the SEC has enacted a series of regulations that have held private equity fund and hedge 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 over the last few years these terms have become essentially interchangeable.

A hedge fund or private equity fund is a largely unregulated business partnership in which the partners pool their capital in the hope of obtaining absolute returns. The primary difference between a private equity fund and a hedge fund is their investment focus or strategy. Private equity funds invest solely in private equity investments while hedge funds may invest in any type of investment.

An absolute return is a measure of gain or loss expressed as a percentage of the total invested. A private equity investment is a security or debt offering that is private – not open to the public. Only “sophisticated investors” may invest in private offerings. A sophisticated investor is an investor who is considered to have the range and depth of investing experience and knowledge to weigh the risks and merits of an investing opportunity.

Both types of funds are structured as limited partnerships with the fund manager as the general partner.

Benefits and risks differ substantially from the more common investments such as public stock purchases, mutual funds, CDs or annuities. Private equity funds and hedge funds present a greater 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 greater.

Mutual funds and other traditional investments seek relative returns which is a simple return on a year over year basis. The benefit in investing in a private equity fund or hedge fund is the potential to receive greater gains than other investments. The risk in these investments is the possibility of losing all your money to mismanagement, market fluctuations or fraud as the investors who trusted Bernie Madoff can attest. Because of these risks, private equity funds and hedge funds require investors to be sophisticated investors.

Participating in one of these funds is open to any person or business that meets the SECs definition of a “sophisticated investor.” A sophisticated investor must also be an “accredited investor” which is any person who has a net worth of one million dollars or more and a net income of at least $200,000 in each of the previous two years. Businesses with assets of at least five million dollars or a president, general manager 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.

Fees associated with these funds may vary but usually are divided 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 return generated by the fund.

Smaller funds are better. A smaller fund has distinct advantages over a larger fund in that it has a greater number of investments to choose from (how many 1 billion dollar investments are available?) and it is easier to achieve a higher level of return. A fund of one billion dollars would have to earn 100 million dollars to achieve a 10% return but a fund of 100 million dollars would have received a return of 100% on the same investment.

There are over 6,500 private equity and hedge funds. Some of the most well-known funds include Mitt Romney’s alma mater, Bain Capital, plus 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, investing strategies and entry requirements. Consultation with your financial advisor and or legal advisor is highly recommended prior to any investment.

This article is provided for informational purposes only and does not purport to provide financial or legal advice of any kind. Neither does it promote or disparage any fund or the private equity or hedge fund industry. Always consult with a financial advisor and or a legal advisor before making any investment decision and never, never invest more than you can afford to lose.

SRI and Hedge Funds – Any Chance for a Marriage?

Socially Responsible Investing – more than a fad?

Fads come and go. SRI might have looked like “flavor of the month” at the first “SRI in the Rockies” conference of 1990, but instead of disappearing, its popularity has increased year-on-year. For last year, the Eurosif (European Sustainable Investment Forum) Report put total SRI assets under management at around € 5 trillion (currently some US $ 7.11 trillion). This includes Core SRI with its positive selection of suitable investments, and Broad SRI with the opportunities that are left after negative screening of unsuitable ones. Any popular investment strategy merits investigation by hedge funds, whose operations are based on reallocating their AUM as returns from different investments vary over time. However, with divergences in investment approaches between hedge funds and SRI, the question so far has been whether they are compatible enough to work together.

It’s not just about money

The dual goals of SRI are to maximize returns while contributing to social well-being by factoring in non-financial criteria. Also described as sustainable or ethical investing, SRI typically champions human rights, social justice, ecological responsibility and corporate correctness. Different forms of SRI have existed for a long time. Refusals to invest in tobacco, arms and alcohol are just some of the historical examples. More recently, corporate greening and respect for the environment are issues that have gained attention. The growing realization by investors of the influence that they can wield on different organizations has led them to scrutinize both investment policies and investment vehicles, and to use that influence to change or boycott accordingly.

Where is SRI headed?

In a word – upwards. The figure for AUM for SRI continues to rise. With strong growth in European and American markets and a sizeable market potential in Asia, projections from organizations like Robeco and Booz & Company are for 25% annual growth and a 15% share of all Assets Under Management worldwide within the next 4 – 5 years. Whether or not the market segmentation remains the same however may be another matter. Today Core SRI is one-third of Broad SRI, the whole market being driven for the most part by institutional investors who hold 92% of the AUM for SRI. Bonds comprise 53% of total SRI assets, and equity just 33% (Eurosif figures for 2010).

SRI returns and performance

How does SRI compare with other investments? There is a temptation to consider SRI as an exercise in investor altruism, where performance is a secondary consideration and restriction in the investment universe leads to mediocre returns. Yet a 2007 study (by Leuven University) on the risk-return of Belgian SRI funds and a 2011 study on French SRI funds (by Capelle-Blancard and Monjon) showed neither underperformance nor over performance when compared to their non-SRI counterparts. Another study by Weber, Mansfeld and Schirrmann showed that a selection of 151 SRI funds performed better than the MSCI World Index between 2002 and 2009. Their conclusion suggests however that in-depth analysis and manager skill is still the most important determinant of performance. If there is any issue, it is that there is no standard approach to integrating SRI into portfolio management. Meanwhile SRI continues to demonstrate respectable returns and more.

A Hedge Fund/SRI stand-off

Pension funds, insurance companies and high net worth individuals are all contributing to the increasing demand for SRI. Hedge funds by comparison seem reticent. In Europe for example (Eurosif 2010), alternatives and hedge fund assets account for a modest 5.6% of total SRI assets. Hedge fund managers have perhaps viewed SRI so far as an eccentric offshoot of alternative investments, while investors have not yet found the alignment they want between hedge funds and SRI. Their problem is not only with the nature of the sectors in which hedge funds invest. It is also with some hedge fund strategy practices like selling short, which restricts possibilities to engage management in the corporations or sectors concerned. Less engagement means less influence and in turn less chance for SRI to achieve its parallel objectives of returns and social justice.

Opening the flood gates

SRI represents an increasingly important potential source of fresh capital for hedge funds. Conversely, if investors want to maximize their influence, hedge funds are a significant lever they cannot ignore. Trading sectors and trading practices may both need adjustment for the two to work together well. The argument for instance that short sales help SRI by reducing the stock price of companies that do not comply with social or environmental standards is short-sighted at best. SRI seeks to encourage compliant organizations, but not to deliberately damage the non-compliant. For instance, when the California Pension Fund withdrew from the Thai stock market in 2002, the Thai Stock Exchange created a SRI fund to protect the better employers from any negative impact.

SRI has also shown itself to be buoyant in the recent global financial woes, growing by 13% in the US between 2007 and 2010 compared to just 1% for other professionally managed assets. SRI has the potential to provide hedge funds a useful diversification of their portfolios and their investor base. In the same way that industrial corporations have often found that going green turns out to be advantageous not only environmentally but also economically, hedge funds may well find that going “SRI” not only satisfies investor demand for social justice, but brings direct financial benefits as well.

Read more about SRI investing and the latest developments in using investments as a catalyst for social change on the blog, The Geneva Globe.

References:

Responsible Investing: A Paradigm Shift Robeco and Booz & Company

European SRI Study 2010 Eurosif (the European Sustainable Investment Forum)

Risk-Return of Belgian SRI Funds Luc Van Liedekerke, Lieven De Moor and Dieter Vanwalleghem

The Financial Performance of SRI Funds between 2002 and 2009 Olaf Weber, Marco Mansfeld, and Eric Schirrmann

The Performance Of Socially Responsible Funds: Does The Screening Process Matter? Gunther Capelle-Blancard, Stephanie Monjon