Hedge Funds & Private Equity Funds $ venture capital

Hedge Funds
In general, hedge funds are only open to institutions and to individuals called accredited investors. An accredited investor has over $1 million in liquid net worth or makes > $200,000 per year. If it's a married couple, the assets held jointly count toward that $1 million figure, or the annual income needs to be > $300,000. The equity in the investor's primary residence is not counted toward the net worth minimum we're talking about $1 million of net worth that could be invested.

Why does the investor need to meet net worth or income requirements? Because these hedge funds often use high-risk trading strategies including short selling, currency bets, and high levels of leverage, etc. If you're an average Joe and JoAnne, it wouldn't make sense to let you risk all of your investment capital on such high-risk investing. On the other hand, if you're a wealthy individual or an institution, chances are your hedge fund investment is just a percentage of the capital you invest. So, if you lose $1 million, chances are you have several more million where that came from.
A typical arrangement for a hedge fund is to have a limited number of investors form a private investment partnership. The fund typically charges 2% of assets as a management fee and extracts the first 20°/0 of all capital gains. Then, they start thinking about their investors (we hope). Once you buy, there's a good chance you will not be able to sell your investment for at least one year. Rather than trying to beat an index such as the DJIA, hedge funds generally go for "absolute positive investment performance"usually 8% or so regardless of what the overall market is doing. In other words, hedge funds are designed to profit in any market environment, while index funds only work when the overall market—or the section of it represented by the index—is having a good year.

Now, although a non-accredited purchaser cannot invest directly in a hedge fund, there are mutual funds called funds of hedge funds, which she can invest in. As the name implies, these mutual funds would have investments in several different hedge funds. In most cases, the investor would not be able to redeem her investment, since hedge funds are illiquid. Also, these investments would involve high expenses, since there would be the usual expenses of the mutual fund, on top of the high expenses of the hedge funds the mutual fund invests in.

Private Equity Funds
Investment company products are open to retail investors. Publicly traded REITs are also open to retail investors, who do not have to sign net worth and risk acknowledgment statements the way they do for privately held REITs and the real estate limited partnerships we'll look at in a few pages.

Private funds including hedge funds, venture capital funds, and private equity funds are also open only to sophisticated investors due to their risky investment strategies and relative lack of liquidity.

Like a hedge fund, a private equity fund is structured as a limited partnership and is open only to sophisticated investors, as it is not liquid and generally takes on much greater risk than an open- or closed-end fund. As the name implies, private equity groups invest in securities not publicly traded. They often approach a company like Frank & Emma's Fruit Pies and cut a deal to buy all the common stock plus maybe a premium. After they appoint some better managers and board members, improve the profits at the acquired company, and get some good media buzz, maybe they then approach investment bankers to do an IPO so the owners can cash in as investors clamor for the stock. Private equity funds are typically set up for a period of time, maybe 10 years. After that, investors receive their money back from the general partner who set up the fund, plus a profit.

The use of leverage is associated with private equity groups, whose acquisitions are often referred to as leveraged buyouts.

venture capital
Unlike private equity investors, venture capital firms typically focus on providing investments to early-stage companies, and rather than using leverage, VC firms typically use cash. Also, while private equity funds typically buy a company outright, venture capital funds typically make smaller investments in several companies in exchange for a minority stake.

While private equity firms usually buy more mature companies, venture capitalists invest in earlier-stage companies. Because most companies will fail, venture capital funds invest smaller amounts in dozens of companies. The "VC" firms who invested early in companies such as Oracle, Microsoft, and Facebook realized mind boggling returns when those companies then offered shares to the public.
Uncovering the next grand-slam is the goal of a venture capitalist. Unfortunately, it's hard to see the future before it arrives.

Private equity investors buy a company they expect to make more efficient and profitable, little risk of failure over the near-term. These investors plan to install new management and run the company for a while themselves. Venture capital investors, on the other hand, know most of their investments will be losers; therefore, the returns are made on the handful of performers that survive and thrive. VC funds provide investment capital with a much more hands-off approach to running the companies in which they invest.

A private equity firm would purchase a company like the makers of Hostess snack cakes, fix it up, and then sell it. A venture capital firm would provide financing to an up-and-coming gluten-free snack cake maker who just did their first $1 million in revenue. And a hedge fund is more of a heavily traded portfolio of securities than a fund providing private investment capital to companies at various stages of their development.

Since mutual fund portfolios are open to retail investors, they can't focus on high-risk investment strategies. But, when the investors are all wealthy individuals and institutions, the regulators can relax a bit. Regulators, remember, provide necessary protection to investors, and sophisticated investors don't need so much protection to keep the playing field level. That's why such sophisticated investors can invest in the private funds we just looked at private equity, venture capital, and hedge funds.
These investors can also invest in direct participation programs.


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