TOC
1. Hedge Funds1.1 History of hedge funds1.2 Hedge fund strategies1.3 Hedge fund locations1.4 Hedge fund investors1.5 Hedge fund fees1.6 Hedge fund redemption1.7 Hedge fund regualtion1.8 Hedge fund prime brokers2. Private Equity2.1 Definition2.2 Private equity structure2.3 Risk and return2.4 PE v.s. Hedge Fund2.5 Business Angels2.6 Private Equity Exit
1. Hedge Funds
1.1 History of hedge funds
The beginning of a era: 1949, Alfred Winslow Jones: “the father of the hedge fund industry”
Price movement of an asset:
- Overall market
- Performance of the asset itself
To neutralize the effect of overall market movement, hedge funds balance their portfolio.
Advantanges and limitations
- Advantages:
- Diversification
- Low correlation
- Absolute returns
- Downside protection
- Limitations:
- Only open to “accredited” or qualified investors
- Fee structure
- Lower liquidity
- High risk
- Unregulated or loosely regulated
1.2 Hedge fund strategies
1.3 Hedge fund locations
Often registered in tax heavens or lightly regulated regime like British Virgin Islands, State of Delaware and Cayman Islands.
Geographically based close to financial centres:
- Close to clients/investors
- Draw talents
- Close to information centres
1.4 Hedge fund investors
Investors contain accredited investors and institutional investors.
Accredited investors:
- Individual net worth, or joint net worth with a spouse, that exceeds $1 million at the time of purchase.
- Or income exceeding $200,000 in each of the two most recent years.
- Or a joint income with a spouse exceeding $300,000 for the two most recent years, and a reasonable expectation of the same income level in the current year.
Institutional investors:
- Bank, insurance company, small business investment company, trust, charity
- Fund of funds: combination of multiple types of funds; allocate funds to hedge funds
- Pension funds under cetain conditins and restrictions
1.5 Hedge fund fees
Fees
- Management fee: 1-2% of net asset value of a fund
- Incentive fee (or performance fee): 20-50%
- The “2 and 20” convention
- High incentive fee has both advantages and drawbacks for investors
- Incentivize managers to generate profits
- But sometimes managers take undue risks
- No widely accepted mechanism forcing managers to share losses (asymmetry compensation)
Hurdle rates: there is no incentive fee if hurdle rate is not achieved:
- Hurdle rates examples: government treasury bill, or a fixed percentage.
- Incentive fee can be paid as a percentage of entire annual return, or only the percentage above the hurdle rate.
1.6 Hedge fund redemption
Clients want to withdraw at an unfavourable time because the demand for liquidity, myopic clients (focusing on short-term results) and lack of confidence, run on fund
Hedge fund managers can set up gates and lockups to restrict fund flow from redemption. Lock up: cannot redeem for a given period; Gate: a cap on the amount that can be withdrawn at one time.
Side pocket
A special account specifically for difficult-to-value or illiquid assets. Set up by the fund manager. An investor cannot redeem any assets in the side pocket until fund manager liquidate it.
1.7 Hedge fund regualtion
Conventional funds
Protect investors. Restricted list of inverstible (safer) assets, e.g. pension fund. Closely regulated by regulators and stock exchanges
Hedge funds
Investors are usually rich individuals and professionals. Underlying rationale: they can protect themselves. Free to invest in a wide range of market and assets. Lightly regulated.
1.8 Hedge fund prime brokers
Primary Broker Service is provided by investment banks, include
- Broker: execute buying and selling orders from fund manager.
- Lend securities (for short selling); essentially providing financing
- Arranging financing leverage
- Clearing and settlement
- Custody services: safe keeping assets, book keeping etc.
Income is from commissions from broker service, spreads from financing and annual fees for certain services (e.g. administration).
2. Private Equity
2.1 Definition
when PE enters during the growth of a company
Private Equity:
Provide medium to long-term finance to companies not listed on stock exchanges.
- It’s not easy to distinguish between private equity and venture capital
- Often, private equity is used as a general term that includes venture capital
- Sometimes, use private equity to refer to investment in established private companies, use VC to refer to investment in early stage and high growth companies
2.2 Private equity structure
General partner
- Fund contribution
- Manage the fund, make investment decisions
- Annual fee
- Carried interest: 20% of the total capital gain
Limited partners
- Fund contribution
- Capital gain
2.3 Risk and return
PE/VC investments are hight risky as they often invest in relatively young firms
- Most PE/VC investments are unsuccessful: Loss for a large proportion of the investments
Extremely high return if an investment is successful (several times of initial investment)
- Diversification is important, invest in multiple firms
2.4 PE v.s. Hedge Fund
Private equity
- Geared towards long-hold, multiple-year investment strategies in illiquid assets
- Have more control and influence over operations or asset management to influence their long-term returns
Hedge fund
- Focus on short or medium term liquid securities and they do not have direct control over the business or asset in which they are investing
- Have less control over the assets and lack in voting power
2.5 Business Angels
Wealthy individuals who provide their own money to be used as capital in new business ventures. Substantial business and entrepreneurial experience. Invest between $10,000 and $250,000; primarily in start-up, early-stage firms; sometimes in expanding firms. Equity finance, debt instruments and preference shares. Usually do not have a controlling shareholding. Willing to invest at an earlier stage that most formal venture capitalists.
2.6 Private Equity Exit
Going Public:
- Most successful type of exit
- Do not sell shares immediately
- VC backed IPOs are more likely to be acquired later
Liquidation:
- Unsuccessful exit
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