Hedge Funds and Private Equity

How hedge funds and private equity firms invest, how they are paid, and the debates over their returns and influence.

Hedge funds and private equity firms manage large pools of money, mainly for wealthy individuals and institutions such as pension funds and university endowments. They are often in the news, but how they work is less widely understood.

Hedge funds

Hedge funds are investment funds that use a wide range of strategies, often more flexible than ordinary funds. They may:

Buy some assets while short selling others.
Use borrowed money to increase their bets.
Trade derivatives, currencies, commodities and bonds.
Bet on events like mergers or bankruptcies.

The name comes from early funds that “hedged” risk by combining long and short positions, but many hedge funds today take large risks.

Private equity

Private equity firms buy whole companies, or large stakes in them, usually taking them off the stock market or buying private firms. They aim to improve the business over several years and then sell it at a profit.

A common approach is the leveraged buyout, where the purchase is funded largely with borrowed money, and the debt is placed on the purchased company. This can magnify returns, but also leaves the company with heavy debts.

How they are paid

Both have traditionally charged fees often summarised as “two and twenty”: a yearly management fee of about 2 percent of assets and 20 percent of profits above a threshold. Fees have come down somewhat in recent years for many funds, but remain much higher than those of index funds.

Do they beat the market?

Research suggests results vary widely. After fees, many hedge funds have not beaten simple, low-cost index funds over long periods. Private equity studies find some top firms consistently earn strong returns, while average returns after fees have been debated.

Private equity and a retail chain

A private equity firm buys a struggling retail chain using mostly borrowed money. It closes weak stores, cuts costs and sells property. In some cases, such changes make the business stronger and it is sold at a profit. In others, the heavy debt leaves the chain unable to cope with a downturn, and it collapses, costing jobs. Researchers have found both outcomes, and debate which is more common.

The debate

Supporters argue these firms improve efficiency, provide capital and help price markets accurately. Critics point to high fees, job cuts in some buyouts, heavy debts placed on companies and tax advantages such as the treatment of “carried interest” in some countries.

Thinking high fees mean high returns

Paying high fees does not guarantee better results. Many studies find that after fees, a large share of actively managed funds, including many hedge funds, underperform low-cost index funds.

Key takeaways

Hedge funds use flexible strategies including short selling, leverage and derivatives.
Private equity firms buy companies, often with borrowed money, aiming to sell them later at a profit.
Both traditionally charged around 2 percent of assets and 20 percent of profits.
Results vary widely, and many funds do not beat index funds after fees.