A Review of Private Investment Funds
What Are Private Investment Funds?
As the term itself suggests, a private investment fund operates in a much smaller and specialised confine as compared to investments that cater to the general public. While conventional mutual funds and mass-market products are offered to the retail segment, on the whole, private investment funds have a different clientele both on net worth and the group size.
Essentially, these funds do not raise capital from the usual market that comprises the typical individual investor. Instead, the investors for these funds are a mix of accredited investors and qualified clients. Members of private investment funds, unlike retail investors, know the financial markets and investments and the ways in which they function.
Under the Investment Company Act of 1940, there are certain exemptions laid down that a private investment fund needs to meet to be classified as one. In particular, it is the 3C1 and 3C7 exemptions that relate to the specific classification.
3C1 states that a fund that comes under this exemption can only have a maximum of 100 accredited investors. Meanwhile, under the 3C7, there can only be up to 2000 qualified purchasers of the fund.
Why Are Private Investment Funds Relevant?
So why do private investment funds exist? How are they better than regular investment funds and under which circumstances does it work better?
Regulations less tight
One of the big advantages that private investment funds enjoy over their conventional public counterparts is the lack of stringent regulations that control them. The prevalence of regulatory supervision can be quite intense in the financial market. The regular public funds operate under a strict framework and are subject to constant monitoring from appellate bodies.
But the private investment funds are governed with less stringent rules and enjoy more operational freedom. Whether it is about the actual transactions or the reporting, there is more leeway here for them.
Ability to work with a wide range of funds
There are some types of funds that public funds might not engage in due to operational convenience. Illiquid funds are a good example as they have a reputation for being difficult investment products when it comes to redeeming them before maturity.
But private investment funds do not shy away from working with illiquid funds.
Less stringent exposure about their position
Often, public funds are under the scanner of not just the regulators but also the investors and the overall market. This could open up scrutiny from the market and the investors that could potentially lead to speculations and opinions about their performance.
But private investment funds are not obliged to reveal their positions publicly. This allows them more opportunities to work without being under the constant market glare.
Ideal for high net worth clients
Private investment funds are best suited to high net worth clients given their demands for an exclusive and customised strategy and products for the vast corpus they need management for. Also, the flexibility that accompanies privately managed funds and the absence of surveillance and spotlight work very well for this clientele and their considerable capital.
Such funds may originate from the private wealth of an affluent family and then evolve into being an investment arm for the family or group business without the enterprise having to go public.
Types of Private Investment Funds
Private investment funds is an umbrella term that refers to a fund that has a limited and more qualified investor base and ticking the requirements under the Investment Company Act of 1940.
The two of the most notable and actively managed private investment fund types are private equity and hedge funds.
Private equity funds
Private equity funds are investment vehicles that are created for high net worth individuals and intended to gain equity ownership of a privately held company. The corpus here is managed by an adviser who invests the money pooled by various private investors in investment opportunities focused on capital appreciation. In this regard, this can be similar to mutual funds and even hedge funds but private equity funds differ in other aspects.
Such investments that are made on behalf of the fund usually have a long time horizon that can run into many years, even up to a decade or more. Those who invest in a private equity fund, therefore, have to be prepared for longer gestation periods for their investments to reap returns. But because the funds themselves are deployed in potentially high yield ventures like the acquisition of equity ownership in companies, the upside promised can be quite high.
Things to know about private investment funds
The purpose of private investment funds is to maximise returns and create more wealth for high net worth clients. Because the intent is to earn a high rate of returns, the vehicles used often involve much more than market investment.
The investment strategies can be diverse and include the venture capital route, providing growth capital and leverage or buyouts for companies or even pumping in funds needed for a turnaround situation. Obviously, this means the initial capital needed to gain entry into these funds are large.
As the capital needed is large, private investment participation is mostly by high net worth individuals or institutional and accredited investors. The business scene is increasingly inundated by start-ups and enterprises looking to ride the wave of the boom driven by technology and globalisation. This is where private equity sees an opportunity to cash in on the growth possibilities of these endeavours and make handsome profits.
Obviously, the participants in such a high capital intensive investment arena will be a filtered lot. Besides wealthy individuals, there is a slew of institutional investment players like insurance companies, pension funds, university endowments, among others.
What are the advantages of investing in private equity funds?
Clearly, there are advantages in taking the private investment funds route for those who have the capital to spare.
There is a large target market that is mostly untapped that always requires additional funds to enhance their business interests. These are usually unlisted and privately owned entities that could have the potential for growth and are in need of an infusion of working capital.
While there is a risk in every investment, private equity funds are managed by talented and experienced professionals who follow a stringent selection process of their investment opportunities.
Also, there is a clear management structure and accountability prevalent in private equity funds that serve to protect shareholder interest.
What are hedge funds?
An investment product that is formed by pooling investments from multiple investors, a hedge fund aims to protect oneself from financial losses by providing the highest investment returns. Several strategies are used to earn returns as quickly as possible.
There is always a risk factor involved with hedge funds – this is because the investments are in highly liquid assets; so the investor aims to take profits quickly on one investment and then moves the profits into another investment with high potential returns. When compared to mutual funds, hedge funds are not regulated by the Securities and Exchange Commission and are more flexible when it comes to investing in a range of securities that may increase the risk of investment losses.
To increase the probability of returns, hedge funds tend to use riskier strategies like leverage or borrowed money. For this reason, the majority of the investors who invest in hedge funds are accredited investors, institutional investors and wealthier investors who can afford the risks of hedge fund investing. Also, when compared to mutual funds and other investment vehicles, hedge funds charge a higher fee - both an expense ratio and a performance fee.
Things you need to know about hedge funds
You need to be an accredited investor - have a minimum level of income or assets with higher risk tolerances.
You need to understand the risk involved in the fund's investment strategies and whether they match with your investing goals, read and understand a fund's prospectus and related materials. Also, make sure you are aware of the fund valuation process and the level to which a fund's holdings are valued.
Keep in mind that hedge fund managers usually charge a sum of an asset management fee and a performance fee. You need to know whether your hedge fund has any limitations on the right to redeem your shares or a lock-up period where you cannot cash in your shares for a specific time.
Make sure your hedge fund manager is competent enough to handle your money and does not have an adverse track record within the securities industry. And finally, read FINRA’s investor alert, which describes some of the risks of investing in hedge funds.
Top Differences between Private Equity Funds and Hedge Funds
Time frame: While private equity funds invest in companies that provide higher profits over a longer period, hedge funds invest in companies that offer good ROI over a shorter period.
Transferability: Private equity funds are close-ended and have restrictions concerning transferability for a period of time. Hedge funds are open-ended without any sort of restriction.
Taxes: The profit earned in private equity funds are not subjected to taxes, whereas, whatever profit earned in hedge funds are subject to tax rates.
Risks: Hedge funds are riskier when compared to private equity funds.
Capital investment: For private equity funds you can invest in funds whenever it is necessary, while, in hedge funds, you need to make a one-time investment.
Participation: While private equity funds investors have an active status, hedge funds investors are passive participants.
Control: Private equity fund investors have more control over operations and asset management when compared to hedge funds investors.
Fee structure: For both the investment funds, the fees charged are 1-2% of the financial assets; for private equity, it is for the funds that are actively managed, while for hedge funds it is for the assets that are under management. For hedge funds, there is a 20% performance fee.
There are risks involved in making an investment in both private equity funds and hedge funds. Before investing in any one of the options, it is vital to understand what each fund will do to your wealth and then choose accordingly.
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