Private Funds
Now that you understand registered fund structures (open-end and closed-end), let's look at funds that operate outside the traditional regulatory framework. Private funds are not registered under the Investment Company Act of 1940, which means less oversight but also more restrictions on who can invest.
What Makes a Fund "Private"?
- Not registered under the Investment Company Act of 1940
- Restricted access: Available only to accredited investors and qualified purchasers - not offered to the general public
- Less regulatory oversight than registered funds (no daily net asset value (NAV), limited disclosure requirements)
- Less liquid than registered funds; redemptions are restricted
The three main types of private funds are hedge funds, private equity funds, and venture capital funds.
Exam Tip: Gotchas
- Private funds are for accredited investors and qualified purchasers only. They are never offered to the general public. If an exam question describes a fund available to anyone, it is not a private fund.
Hedge Funds
Hedge funds use aggressive, flexible strategies to pursue returns that are often uncorrelated with the broader market.
Strategies:
- Short selling
- Leverage (borrowing to invest)
- Derivatives (options, futures, swaps)
- Concentrated positions (large bets on few securities)
Structure and fees:
- Typically organized as limited partnerships (manager is the general partner, investors are limited partners)
- "2 and 20" compensation: 2% annual management fee on assets under management + 20% of profits
- Many funds use a high-water mark - the manager only earns the performance fee on gains above the previous highest NAV, so investors don't pay twice for recovering from losses
Liquidity constraints:
- Lock-up periods restrict redemptions (often quarterly or annually)
- Limited transparency; investors may not know the full portfolio
- Illiquid compared to mutual funds or exchange-traded funds (ETFs)
Exam Tip: Gotchas
- Hedge funds are organized as limited partnerships, not corporations. The manager is the general partner; investors are limited partners.
Private Equity Funds
Private equity (PE) funds invest in private companies or take public companies private, aiming to improve operations and sell at a profit.
- Long investment horizon: Typically 7-10+ years before investors see returns
- Capital calls: Investors commit a total amount upfront, but the fund draws (calls) that capital over time as it identifies investments
- Exit strategies: The fund profits by:
- Taking the company public through an initial public offering (IPO)
- Selling the company to another buyer
- Secondary sale to another PE fund
- Fee structure: Also commonly uses "2 and 20," but often applied to committed capital (not just invested capital), and performance fees may be subject to a hurdle rate - a minimum return the fund must achieve before the manager earns the performance fee
Venture Capital Funds
Venture capital (VC) funds are a subset of private equity that focus specifically on early-stage companies.
- Invest in startups and early-stage companies with high growth potential
- Very high risk with the potential for very high returns; many portfolio companies will fail, but a few big winners can drive overall fund returns
- Active involvement: VC managers often take board seats and provide strategic guidance to portfolio companies
- Longer timelines than even traditional PE; depend on portfolio companies achieving growth milestones
Exam Tip: Gotchas
- Venture capital is a subset of private equity, not a separate category. VC funds focus specifically on early-stage companies, but they fall under the broader PE umbrella.
Private Fund Comparison
| Feature | Hedge Fund | Private Equity | Venture Capital |
|---|---|---|---|
| Investment targets | Public markets (stocks, bonds, derivatives) | Established private companies | Early-stage startups |
| Time horizon | Short to medium | 7-10+ years | 7-10+ years (or longer) |
| Typical strategy | Long/short, leverage, derivatives | Buy, improve, sell companies | Fund startups, scale, exit |
| Liquidity | Lock-up periods; quarterly/annual redemptions | Very illiquid; capital locked for fund life | Very illiquid |
| Risk level | Varies by strategy | High | Very high |
| Fee structure | 2% mgmt + 20% profits (high-water mark) | 2% mgmt + 20% profits (hurdle rate) | 2% mgmt + 20% profits |
| Manager involvement | Trades portfolio | Restructures/manages companies | Board seats, strategic guidance |
Exam Tip: Gotchas
- Capital calls (PE/VC) and lock-up periods (hedge funds) both restrict liquidity, but differently. Capital calls mean investors commit money that is drawn over time. Lock-up periods mean invested money cannot be withdrawn for a set period.
- "2 and 20" is the standard fee across all three types, but the details differ. Hedge funds use a high-water mark (performance fee only on gains above the previous peak). PE funds often use a hurdle rate (minimum return before the manager earns the performance fee).