Private Funds

Now that you understand registered fund structures (open-end and closed-end), look at funds that operate outside that framework. Less regulatory oversight cuts both ways: managers get more strategy flexibility, but investors get fewer disclosure protections.

What Makes a Fund "Private"?

• Not registered under the Investment Company Act of 1940
• Not broadly offered to the general public: investor eligibility depends on the fund's investment-company exclusion and securities-offering exemption. Accredited investor and qualified purchaser are distinct standards and are not automatically required together
• 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

• Accredited investor and qualified purchaser are two distinct, separate standards. A fund's eligible investors depend on which investment-company exclusion and securities-offering exemption it relies on, not on satisfying both tests at once. Never assume a private fund requires both.
• Private funds are not 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 bar redemptions for an initial period; afterward, redemption windows are often periodic (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 typically organized as limited partnerships. In that structure, the manager is the general partner and 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

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 a common fee structure 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).

What Should You Check on Exam Day?

• Private funds are not registered under the Investment Company Act of 1940 and are not broadly offered to the public; investor eligibility turns on the fund's exclusion and exemption, not a single fixed test.
• Hedge funds are typically organized as limited partnerships and use lock-up periods; private equity funds use capital calls and hold investments for 7-10+ years, and venture capital funds often hold even longer.
• Venture capital is a subset of private equity focused on early-stage companies, not a separate category.
• "2 and 20" is common across all three, but hedge funds typically apply a high-water mark while private equity funds often apply a hurdle rate instead.