An investment fund is a special-purpose company which pools the money from many passive investors for collective investment under the management of professional investors. There are several different types of investment funds, differing by (1) the types of assets the fund invests in and the investment strategies used by the fund, (2) the fund structure (a term which generally means the type and amount of fees paid to investment managers, the minimum time that fund investors must leave their money with the fund, and various provisions for what happens in terms of fees and investment lock-ups under various good and bad scenarios), and (3) the laws & regulations which apply to a particular type of fund.
Three common fund types are private equity funds, hedge funds, and venture capital funds. What are the differences between these fund types?
Private equity (PE) funds invest in companies not listed on public stock exchanges. Venture capital (VC) funds also invest in unlisted private companies, but they focus on very young, high-growth companies whereas PE funds focus on older, lower-growth companies. Hedge funds are extremely general and may invest in just about anything.
Those differences in investment strategies among PE funds, VC funds, and hedge funds also motivate differences in fund structure since the risks and time horizons for each type of fund tend to differ substantially. In addition, for funds either based in the U.S. or which have U.S. investors, the laws and regulations differ somewhat for the different types of funds.
Investment Strategy Comparison
Private equity funds invest in the equity and/or debt of unlisted private companies. One common PE strategy is to buy a private business that has a bad management team, replace the management team, renovate the business’s processes to make the business more efficient, and then sell the now more valuable company for a higher price than when it was purchased. Another common PE strategy is to buy stock in small- to medium-sized cash-flowing private businesses which aren’t advertised as for-sale but which have owners that can be talked into selling a percentage of their business.
A venture capital fund invests in start-ups. Sometimes these start-ups have revenue, but sometimes the start-ups are such early-stage companies that they don’t even have revenue yet. Very commonly, even if a start-up getting VC investment does have revenue, it won’t yet be profitable as it will be spending more on R&D and expansion than it is taking in through sales.
A venture capital fund could be considered a type of private equity fund since start-ups are unlisted companies, but the vast majority of investors use the term venture capital with the additional connotation of investing in very young companies with both high risk of failure of each company invested in and a high (e.g. 10-fold or 100-fold) potential return for each company which doesn’t fail.
The term ‘hedge fund’ is used very flexibly for a huge variety of different types of investment funds. Some hedge funds invest exclusively in publicly traded companies, others invest exclusively in physical commodities, others invest exclusively in cryptocurrencies, and yet others invest opportunistically in all of those asset classes and in others as well such as real estate, art, and abstract assets like interest rate swaps.
Unlike PE funds and VC funds, some (but not all) hedge funds use stock shorting, stock and commodity futures, and/or options to profit from market drops instead of just gains.
Fund Structure Comparison
Investment professionals often talk about “fund structure”. This term refers to the conditions, timing, and amount of fees paid to fund managers, whether various expenses incurred by the fund are paid by the fund manager or by the investors in the fund, the minimum investment required to invest in the fund, the minimum time an investor must leave their money in the fund before getting their money back, the conditions under which an investor may be required to leave their money in the fund longer than expected, whether certain investors have priority for getting their money back first, and how specific market and fund conditions may affect both fees paid by investors to managers as well as investors’ abilities to remove their money from the fund.
Fund structure can vary significantly from fund to fund, but on average, the three types of funds under discussion tend to be consistently differentiated along the dimensions of minimum investment time and the open-ended vs closed nature of a fund’s capital contributions,
Minimum Investment Time
Venture capital funds tend to require investors to commit their money for the longest periods of time, frequently 10 years. The reason for this is that VC funds are investing in start-ups which often take a long time to ramp up their business and either become profitable, get acquired, or list their stock on a public stock exchange.
Private equity funds take second place, with investors often required to commit funds for 3-5 years.
Hedge funds usually offer the most liquidity, with typical minimum investment times ranging from one month to one year.
Open vs Closed Fund
An open fund is a fund where investors may contribute money from the fund at multiple different times. A closed fund is a fund where investors must all contribute their money at the same time and then cannot contribute any more money to the fund.
Venture capital funds are almost always closed funds. Private equity funds are also most commonly set up as closed funds. In contrast, hedge funds are most commonly open funds, although there are closed hedge funds as well.
Legal & Regulatory Comparison (in the United States)
In this section, we will focus exclusively on U.S.-based funds, although many countries have similar legal & regulatory regimes governing investment funds.
Of the three types of funds under discussion, venture capital funds are the least regulated, followed by private equity funds which are moderately regulated, and finally hedge funds which have widely varying levels of regulation depending on the type of investments they make but which tend overall to be the most regulated type of private investment fund.
Investment funds have to interact with at least two types of legal & regulatory rules: securities rules and tax rules. In addition, some funds have to deal with commodities rules.
Securities Rules
Private equity funds, venture capital funds, and hedge funds are all examples of private investment funds. Private investment funds are in contrast to public investment funds such as ETFs (exchange-traded funds) and mutual funds. All private funds are exempt from certain securities rules that publicly traded funds must comply with. In addition, the managers of public investment funds must comply with all requirements of the Investment Advisers Act, whereas the managers of private funds may be exempt from some or all of those requirements.
Managers of venture capital funds have the easiest time. Subsection l (lowercase L) of 15 U.S.C. 80b-3 provides a blanket exemption for VC fund managers from essentially all the requirements of the Investment Advisers Act.
Managers of private equity funds and hedge funds have more complex rules that determine whether or not they are exempt from some or all of the requirements of the Investment Advisers Act. Amongst other considerations, PE and hedge fund managers must comply with all rules of the Act if they manage more than a threshold amount of money in their funds.
Commodities Rules
When it comes to commodities rules, both venture capital and private equity funds are generally exempt since they only invest in the stock of businesses.
Hedge funds may or may not be governed by commodities rules, depending on what assets they trade. In addition to hedge funds that trade commodities futures, hedge funds that trade cryptocurrencies must generally comply with commodities rules as most cryptocurrencies have also been deemed to be commodities by the CFTC.
Tax Rules
The taxes for both managers of and investors in venture capital funds are pretty simple, with the income for both almost always treated as long-term capital gains.
The tax situation for private equity funds can be slightly more complex, depending on whether or not the fund holds its stock in private companies for at least 3 years.
The tax situation for hedge funds is the most complicated. Investor income may come in the form of a split between long and short term capital gains or purely as one or another, depending on both a fund’s strategy and on any trading tax elections the fund manager has made with the IRS. Hedge fund managers must also take care to perform careful tax optimization across the various trading tax rules such as wash sale rules and optional trader tax elections.