Hedge Fund

What is the difference between a private equity fund and a hedge fund?

A Private Equity Fund and a Hedge Fund might sound similar to people who are not too familiar with the alternative investment industry. There is a huge difference in the way in which investment is made in these industries.

Private Equity fund includes privately managed pools of capital that is invested in companies, most of which are not listed on the stock exchange yet. There might be a few commonalities in the structure of a private equity fund and a hedge fund, but the major difference is in their investment strategies. Private equity funds ideally invest for a longer term in private companies and anticipate capital appreciation based on the growth and sustainability of the companies that they have invested in. It can also involve merger and acquisition of companies. Private equity definitely is a higher risk investment as compared to stocks or bonds, but also the returns expected are a lot higher. Investors and fund managers in private equity funds should understand the high risk high return principle. Private equity fund managers might offer their advice to a growing or start up company to help it grow towards a suitable position for an IPO (initial public offering).

For Hedge Funds, there is a no defined pattern and area of investment. It is an unorganized investment and is also not allowed in some countries as it is hard to monitor. A hedge fund generally invests in stock markets (short term), real estate, bonds, other funds and privately owned companies. It is a lot more riskier than Private Equity funds, but the returns can be higher when compared (higher risk higher return). The privately managed investment pools in a hedge fund are not subject to Securities and Exchange Commission (SEC) examinations. 

What is Venture Capital?

Venture capital is a subset of private equity. It involves equity investments, ideally in comparatively newer companies (as compared to typical private equity investments) which are just launched or planning a start up or for expansion of a business. Venture Capital funds invest in young companies often developing a new product or technology.

Venture capital is majorly categorized by the progress of development of the company ranging from early stage capital investment used for the initiation of the start up companies to late stage and growth capital investment that is used to fund growth of business that is generating profit but might not yet be profitable or generating enough capital to fund future growth. 

Entrepreneurs often come up with ideas and products that require substantial amount of capital in the start up stage or for the first few years. Many entrepreneurs do not have enough capital to finance the business by themselves, and they must therefore seek outside financing. The venture capitalist's need to generate high profits to compensate for the risk these investment which makes venture funding an expensive capital source for companies. Venture capital is most appropriate for businesses with large capital requirements which cannot be financed by cheaper alternatives such as debt.

Exceptions that might occur

There can be various complex and unexpected cases that can occur during the life of the fund. We will cover a few examples and understand how to handle such situations or how such situations are handled in a fund.

Suppose an LP comes up and asks for split in its capital commitment. This means that he would like to share his commitment with some other LP in a defined ratio. In that case all the previous contributions (draw downs), expenses, investments, undistributed incomes of the original will be re-allocated among the new ratios between these LP's. How to handle distributed income remains in the hands of people involved in the split because that amount is already in the hands of original LP.

Let us understand with numbers, the case of split.

The last figures as per continuing example from my previous posts that we had are as follows:

	CC	CC Ratio	Drawdown	Investment	Mgmt Fees	Deal Exp	Non Deal Exp	Cash Balance
LP 1	10	7%	2	1.00	0.2	0.07	0.07	0.67
LP 2	20	13%	4	2.00	0.4	0.13	0.13	1.33
LP 3	30	20%	6	3.00	0.6	0.20	0.20	2.00
LP 4	25	17%	5	2.50	0.5	0.17	0.17	1.67
LP 5	15	10%	3	1.50	0.3	0.10	0.10	1.00
LP 6	50	33%	10	5.00	1	0.33	0.33	3.33
	150		30	15	3	1	1	10

Now suppose LP #6 decides to split his commitment among himself and a new LP, LP #7. (Note that split can happen between existing as well as new LP's.) He decides to keep a capital commitment of 30 wheres decides to pass on capital commitment of 20 to the new LP #7.

The new figures will be calculated on a pro rata basis between the 2 LP's. Let us see how their holdings and allocations change:

	CC	CC Ratio	Drawdown	Investment	Mgmt Fees	Deal Exp	Indirect Exp	Cash Balance
LP 1	10	7%	2	1.00	0.2	0.07	0.07	0.67
LP 2	20	13%	4	2.00	0.4	0.13	0.13	1.33
LP 3	30	20%	6	3.00	0.6	0.20	0.20	2.00
LP 4	25	17%	5	2.50	0.5	0.17	0.17	1.67
LP 5	15	10%	3	1.50	0.3	0.10	0.10	1.00
LP 6	30	20%	6	3.00	0.6	0.20	0.20	2.00
LP 7	20	13%	4	2.00	0.4	0.13	0.13	1.33
	150		30	15	3	1	1	10

In practical scenario, a split happens most of the times between husband and wife, to reduce the burden of tax  on profits.

There can be cases where an LP defaults or does not intend to pay any drawdown amount from now on. These cases can be handled in a variety of ways. In most cases, the Contribution Agreement of the fund also gives a lot of flexibility in handling such cases. A lot of options are mentioned and one of those can be executed in case of a default.

Options like

• capping his capital commitment to that extent where the capital commitment of the whole fund reduces by the amount unpaid by that LP. 
• returning only his contributed amount and not the profit portion on that amount while distributing in the end. 
• forfeit all his amount.
• return some percentage of the amount contributed by him.
• in some cases, he will be a part of all future expenses (not investments) as well by the cash portion remaining and the profits on his investments will be allocated to other LP's and not to him. 
• any other options as per the funds discretion. 

Indirect Incomes and closings

Let us understand a basics of different Indirect Incomes that can be generated during the life of the fund.

There can be Premium Income generated from LP that has entered in a subsequent closing.

For understanding this, let us understand what is a closing.

Whenever AMC asks for a draw down from all investors, it is referred to as a closing. A fund can have one or more closings. After the final closing is declared, no more money can be drawn down from the investors even if there is still some uncalled amount out of the commitment amount previously decided for the LP's.

Now suppose that a few LP's have invested in the first closing. The first closing happens at the start of the fund for the fund to have some cash for meeting expenses and investment needs. Then as and when the fund finds good investment horizons, it asks for further drawdowns.

Now suppose a new investor decides to enter the fund at the second or some subsequent closing. He will be asked to pay a premium which will be allocated to all the LP's that were present in the previous closings.

This new LP will take a place in all the previous expenses as well as investments. He will be treated as if he was in the fund from the very start. This means that the other LP's investment holdings in the previous investments will reduce as they make place for this LP. Let us understand this with the help of numbers.

An equal percentage of drawdown will be taken from this new LP to get it on par with other LP's. The previous (before entry of new LP) allocation of expenses and investments at LP level are as follows:

	CC	CC Ratio	Drawdown	Investment	Mgmt Fees	Deal Exp	Indirect Exp	Cash Balance
LP 1	10	10%	2	1.50	0.2	0.10	0.10	0.10
LP 2	20	20%	4	3.00	0.4	0.20	0.20	0.20
LP 3	30	30%	6	4.50	0.6	0.30	0.30	0.30
LP 4	25	25%	5	3.75	0.5	0.25	0.25	0.25
LP 5	15	15%	3	2.25	0.3	0.15	0.15	0.15
	100		20	15	2	1	1	1

After the new LP (LP  #6) comes in with a capital commitment of 50 and contributes 20% to be in par with other investors, the re-allocation of numbers based on the new Capital Commitment (CC) ratio will be as follows:

	CC	CC Ratio	Drawdown	Investment	Mgmt Fees	Deal Exp	Indirect Exp	Cash Balance
LP 1	10	7%	2	1.00	0.2	0.07	0.07	0.67
LP 2	20	13%	4	2.00	0.4	0.13	0.13	1.33
LP 3	30	20%	6	3.00	0.6	0.20	0.20	2.00
LP 4	25	17%	5	2.50	0.5	0.17	0.17	1.67
LP 5	15	10%	3	1.50	0.3	0.10	0.10	1.00
LP 6	50	33%	10	5.00	1	0.33	0.33	3.33
	150		30	15	3	1	1	10

One thing to be noted is that the Management fees total amount was increased because this fees is calculated as a percentage of LP's Capital Commitment. So others previous and new Management Fees was the same, just the new Management Fees of the new LP got added to those.

Now as the new LP gets a part in all the old investments, whose value must have increased over the time. The new LP takes part in them and the holdings of old investors is reduced in it, as we can confirm with the above numbers.

To compensate the old LP's for reduced share in these investments and for the increased value of these investments, the fund charges Premium Amount to that LP which is allocated to other LP's why were present in the previous closing. This amount is generally a percentage of amount contributed by the LP in that closing and is generally mentioned in the Contribution Agreement.

But practically what we have seen is, the AMC waives premium charges to the incoming LP to maintain good relations with the new investor.

Now let us understand Late fees Income for the fund.

Whenever a drawdown call is sent to LP's, it goes with a call date (when the drawdown is generated) and a due date (deadline for the amount to be paid). If an LP pays after the due date, he is subjected to pay a Late Fees which is allocated to other LP's. In some rare cases, we have seen that this income is allocated to all the LP's including the one who pays it. And in practical scenario, this fee is generally waived by the fund to maintain good investor relations.

General Indirect Income


Other Indirect Incomes can be generated through some short term investments that the fund must have made with the extra cash lying with it, before that was invested in the portfolio companies.