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.