Hedge Funds & Private Equity

Hedge funds and private equity are alternative investments typically available only to wealthy, sophisticated investors. Understanding their characteristics, strategies, and risks is important for investment advisers.

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Hedge Fund Overview

Hedge funds are privately offered pooled investment vehicles that use sophisticated strategies to generate returns.

Characteristics

Legal Structure

Hedge funds typically avoid Investment Company Act registration through exemptions:

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Hedge Fund Fee Structure: "2 and 20"

The traditional hedge fund fee structure includes both management and performance fees.

Components

Example Calculation

Fund size: $100 million Annual return: 15% ($15 million profit)

High-Water Mark

Many hedge funds use a high-water mark provision:

• Performance fees only charged on new profits
• If fund loses money, must recover losses before earning performance fees
• Protects investors from paying incentive fees after losses

In Practice

If a hedge fund declines 20% one year, then gains 15% the next year, the high-water mark means no performance fee in year 2 (fund hasn't exceeded its previous high). The fund must first recover to the high-water mark before charging incentive fees again.

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Common Hedge Fund Strategies

Directional Strategies

Market Neutral Strategies

Event-Driven Strategies

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Hedge Fund Risks

Lock-Up Periods

Hedge funds typically restrict redemptions:

• Initial lock-up: 1-2 years before any redemption
• Redemption frequency: Quarterly or annually
• Notice period: 30-90 days advance notice
• Gates: Limit on percentage that can be redeemed

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Private Equity

Private equity involves investing directly in private companies or taking public companies private.

Types of Private Equity

Venture Capital

Leveraged Buyouts (LBOs)

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Private Equity Structure

Fund Structure

Private equity funds typically structured as limited partnerships:

Capital Calls

Unlike mutual funds, PE investors don't invest all capital upfront:

1. LPs commit capital (e.g., $10 million)
2. GP calls capital as investments are made
3. Capital called over 3-5 years
4. Called capital is invested in portfolio companies
5. Returns distributed as investments are exited

The J-Curve

Private equity returns typically follow a "J-curve" pattern:

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Investor Requirements

Accredited Investor

To invest in most hedge funds and private placements:

Qualified Purchaser

Required for 3(c)(7) funds with fewer restrictions:

On the Exam

Accredited investors qualify based on income ($200K/$300K), net worth ($1M), or professional credentials (Series 65 in good standing). Qualified purchasers have higher thresholds ($5M in investments) and can invest in funds with fewer investor limits.

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Fund of Funds

A fund of funds invests in multiple hedge funds or private equity funds rather than directly in securities.

Advantages

Disadvantages

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Key Takeaways

• Hedge funds charge "2 and 20" (2% management fee + 20% performance fee)
• High-water mark protects investors from paying incentive fees after losses
• Hedge fund strategies include long/short, global macro, event-driven, and market neutral
• Lock-up periods restrict redemptions; investors face illiquidity risk
• Private equity includes venture capital (early stage) and buyouts (mature companies)
• PE uses capital calls over time rather than lump-sum investment
• Accredited investor: $200K income, $1M net worth, or Series 65 holder
• Qualified purchaser: $5M in investments (higher threshold than accredited)