Difference Between Private Equity, Hedge Funds and Venture Capital

When I went through college and even through my first year as an investment banker, I had absolutely no idea what the main differences were between all the various buyside roles. At first, I was a little surprised to hear that practically everyone wanted to move to the buyside. It was the promise land they said!

But how did they know? They were my fellow banking analysts and they themselves have never worked at a buyside role. Everything I heard was hearsay and just not reliable.

There are a ton of misperceptions out there of what the main differences are between private equity, hedge funds and venture capital. Most of what you read is written by people who have absolutely no idea what they are talking about. Now that I have worked on the buyside for some time and have friends who work on the buyside, I have a better sense of what all these various roles mean and the key differences between them.

Private equity is the traditional path where most banking analysts end up. Hedge funds seem to be a little more mysterious and somewhat harder to break into unless you have a true passion for investing in the public markets. And lastly, venture capital is the least taken path of banking analysts, but seems to have grown as an exit option these past few years given the rise of unicorn companies (startup companies with $1Bn+ valuations).

Fund Structure

Most funds are structured around the 2 / 20 concept (2% management fees, 20% incentive fees). Given the rise in low cost passive investing over the past decade, this fee structure has become pressured. A lot of smaller funds are not able to charge the standard level of fees while those with great track records tend to be able to keep a high level of fees.

Private equity and venture capital investments tend to be in the private market, so it is hard to sell their stakes at any given point in time. Usually, these firms need to wait for a monetization event either through a sale or an IPO to realize value. Given this dynamic, their funds are structured so that the money is locked up for 8-10 years. Usually there is a four-year investment horizon followed by a four-year harvesting period before investors in these funds get any of their money back.

On the other hand, most hedge funds have a different structure that allows investors to redeem their capital in a relatively short amount of time (less than 1 year). Given most investments are in public equities, hedge fund managers can sell their investments if any of their investors redeem their capital. Sure, there are hedge funds that have locked up money as well (I actually work at a hedge fund that has long-term locked up capital), but that is usually not the case in the industry.

Why does having locked up money matter?

Well it goes without saying that firms with locked up money are much more stable than firms that don’t have locked up money. If a hedge fund has a big down year, then investors can redeem and the hedge fund no longer receives those management fees that they used to pay firm expenses (employee salaries, rent, etc.).

With locked up money, you do not have to care about short-term performance as capital is locked-up and management fees are received for the duration of the fund.  

Investor Base

Usually the investor base changes as funds become larger. When funds are smaller, they have more individual investor / family office / fund of funds type capital. As they grow and start having a track record, then pensions / endowments / hospitals will provide the bulk of the capital.

The latter investor base tends to be “stickier” and longer-term oriented. There are usually no main differences in investor bases between private equity, hedge funds and venture capital as it is all over the place depending on the fund. However lately over the past decade, “stickier” money has shifted more towards private equity and venture capital given returns have be very good relative to hedge funds.

This is a recent phenomenon and cyclical in my opinion. The consensus view now is that passive investing will always outperform active, so money has flowed away from active hedge fund managers over the past decade. This will likely change once passive investing starts to underperform active managers.

Investment Time Horizon

Given the locked-up capital of private equity and venture capital funds, their investment horizons tend to be substantially longer than most hedge funds (at around 5-10 years). It varies at hedge funds depending on the type of fund.

On one end of the spectrum, you have the multi-manager hedge funds like Citadel / Millennium / Point 72 / Surveyor that invest over 3-9 months based on a company’s quarterly earnings. Would read about the life at a multi-manager hedge fund if interested in learning more.

On the other end, you have the tiger cubs, deep value investors and activist funds that invest over a multi-year horizon. It is really all over the place and depends on the hedge fund’s investment style.

Most hedge funds these days have moved to a shorter time horizon when choosing investments given hedge fund investors have become increasingly impatient and focused on shorter-term returns.

Investment Style

Depending on the fund, investments styles vary significantly. On one hand you have the deep value distressed players and on the other you have the venture capital / growth equity guys who have a growth mindset.

The distressed players tend to buy dollars for fifty cents. They look to find good cash flowing businesses that trade at cheap valuations because of a temporary issue (i.e. over-levered, liquidity constrained, accounting restatements, large legal liabilities, cyclical pressures, etc.) and are willing to go through the bankruptcy process to realize that value.

The venture capital / growth equity players are the opposite. They look for businesses that have the potential to grow topline quickly, regardless of cash flow (at least in the early stages). A lot of the due diligence in these firms lies less around the financial numbers and more around determining if the start-up founder has the characteristics to be successful. It is more of a qualitative analysis in general.

You will come across numerous different investment styles when looking at private equity firms and hedge funds. Firms will either have a value-oriented mindset (meaning they will not ever buy anything for more than ~8x EBITDA) while others are willing to invest in growthy type businesses for higher multiples.

Asset Class Focus

The asset class focus of a fund depends entirely on the investment style and the expertise of the founders of the fund. Every private equity firm or hedge fund can focus on any type of asset class.

The asset class that a fund can invest in usually depends on how long the capital is locked up. Firms can venture into more illiquid / private securities if the capital is locked up for a long period, which is the case for private equity firms. Like discussed before, most hedge funds have redemption periods of less than a year, so they usually focus on public securities that they can move in and out of very quickly if needed.

There are distressed firms that call themselves hedge funds but operate in a private equity style manner. Distressed securities are usually more illiquid than public equities, so the fund needs to have a private equity type structure to match the investment horizon.  

Venture capital firms usually all focus on the same asset class: early stage companies with minimum revenues, but large potential for growth. Then you have growth equity firms, which like venture capital, focus on companies that have high potential for growth. However, these firms focus on investing in more established start-ups – those that have already raised a couple rounds of funding.

A word of advice – stay away from firms that invest in illiquid securities and do not have locked-up capital. These funds are a disaster waiting to happen. You do not want to worry about your fund blowing up because the firm has to sell illiquid securities at fire sale prices because of redemptions that happen in volatile markets.

Investment Sizing and Concentration

Sizing of investments entirely depends on how large a fund is. To state the obvious, larger funds invest more capital (from a dollar amount perspective) in each investment. How concentrated a fund is in each investment depends on the risk tolerance of the founder(s).

Venture capital firms do not like to concentrate capital in individual investments, but rather place numerous small bets in various startups. Venture capital funds can’t afford to be concentrated given the firms they invest in are early-stage and are more likely to fail compared to an established company that generates profits.

Private equity and hedge funds can be as concentrated as they want to be depending on the parameters set by investors when the fund was raised. In general, concentration is not a bad thing. It can be extremely risky if the firm has no idea what they are doing, but most extremely successful firms with great track records have had times when they were extremely concentrated (i.e. 30%+ of the firm’s capital in a single investment). Just read about Warren Buffett during his early years as an investor.

Multi-managers have low risk tolerances given the leverage on the entire platform. Typically, portfolio managers at these firms do not make concentrated bets since the risk limits are extremely tight and your whole team can get let go if you lose a certain amount of money. You usually won’t see a portfolio manager investor more than 2-3% of allocated capital in a single investment. Can read more about how a multi-manager is structured here.

Hierarchy and Compensation Structure

This is highly variable depending on what type of fund you join. In private equity and venture capital firms, compensation tends to be more structured and dependent on your level within the firm.

Just like in banking, private equity has similar promotion levels (i.e. Associate, Senior Associate, VP, Principal, Partner). You get paid more as you move up the ladder and once you are more senior, your compensation mix shifts to align with the returns of the fund. More on Private Equity Salary and Bonuses here.

Hedge funds usually have a flatter structure, although I do know of some funds that have a private equity type promotion structure as well. Most people stay as an “analyst” for a long time until they are given responsibility to manage their own sector or pool of capital. Compensation is less structured as you get more senior and is entirely based on the returns of the fund. So pay levels can swing significantly from year to year.

For differences between compensation, read Investing Banking, Private Equity and Hedge Fund Salaries and Bonuses.

Is private equity, hedge funds or venture capital the best path for you?

For someone new to the buyside world, you may be thinking “who cares what type of fund I join, all that matters is that I break into the buyside!”

This is not the right mentality to have. You need to be thinking longer-term about what you really want to do because your success over the long run will be tied to whether you are actually interested in what you are doing.

Most people who transition to the buyside end up leaving after two years. They bounce once they realize that the buyside is not all that cracked up to be. They finish their associate program and bounce to corporate development, startups or other types of exit opportunities.

On a side note, if you are wondering why anyone would ever choose to leave the “promise land,” here are the few reasons I have heard over the years from my friends and colleagues:

• Work / life balance still not that great
• Want to do something meaningful for work (what I call the “Millennial Problem”)
• Tired of working in a “soul-sucking” career
• Want to feel like I am building something, a product / service / company
• Going to business school to reset and try to figure out what I really want to do (business school is a huge waste of time and money in my opinion)
• Was not given the option to stay (AKA not fit for the role)

How to know which buyside path is best for you.

Let’s start with private equity.

If you never really had an interest in the stock market and are more into getting involved deeply with the companies that you invest in, then private equity is likely the best path for you. Depending on the fund you join, you are very hands on with your portfolio companies. You talk to management teams, sit in on board meetings, think about longer-term strategy and ways to cut costs, improve margins, etc.

Now you are not as operationally hands on at private equity firms as say those employees who work at those firms. It is more of a higher-level view, but you still get some exposure.

Additionally, in private equity you interact with multiple parties (i.e. lawyers, accountants, management teams, bankers) and run buyside and sellside processes. If you enjoy working in groups and with others, then this is definitely the path to take.  

Moving onto hedge funds

If you love following stocks and reading about market trends, then hedge funds may be a better path for you. In this industry you are more of a passive minority investor and in most cases (unless you are thinking about joining an activist fund), you take a hands-off approach and let management run the company.

The role of a hedge fund analyst is an extremely introverted one (one thing that I did not realize as much before I broke in). Unlike private equity, you are not running processes and talking to multiple counterparties. For 80% of the day, you are sitting at your desk reading filings, transcripts and industry research. For the other 20% you are talking to others on the buyside / sellside, going to conferences, talking to management teams and industry experts.

The hedge fund role is geared more for the introverted types, so make sure you understand all of this before considering joining the industry.

And lastly, venture capital

I’ll admit, I have less knowledge about venture capital because I have never worked in the industry and most of my friends did not end up going this route. That said, venture capital is for those people who are interested in startups and entrepreneurship. It is less quantitative in nature relative to the work in private equity and hedge funds given you don’t focus much on the financials and profitability of a startup.

A lot of the people I know in venture capital are essentially networkers. They reach out and meet with founders to learn more about their businesses and overall vision. They are trying to gauge whether the founder is the right person to lead a company from the early stages to a more developed firm. A lot of the focus will be on the founder and whether he can be successful building a business. There is not much analytical thinking involved.

To sum it all up:

• Private equity is for those who want to be more involved with their investments from a strategic / operational point of view
• Hedge funds are for those introverts who love reading about the market and analyzing stocks
• Venture capital is for those interested in tech / entrepreneurship