Hedge funds and private equity funds - spot the difference

What's the difference between a hedge fund and a private-equity fund? Easy. One speculates in bonds, stocks, currencies and commodities, using leverage and derivatives, while the other uses its own capital and borrowed money to buy companies, improve them and then sell them on.

Well, not so fast. The evidence suggests that hedge funds and private-equity funds - the two hottest growth sectors of the financial universe for the past five years - are converging.

What seems to be emerging is a new type of alternative investment fund that shrugs aside traditional ideas of risk and seeks the highest returns any way it can.

At a recent conference in Frankfurt, David Rubenstein, a co-founder of Carlyle Group, the world's third-biggest buyout firm, said private-equity and hedge funds might eventually converge.

"Funds may be created that have the combined characteristics of private-equity and hedge funds," Rubenstein said.

Carlyle, based in Washington, estimates that there are 9,000 hedge funds with investments worth about $1trillion, while 3,000 private-equity funds have $150bn in assets worldwide.

There is certainly no shortage of evidence of the two types of fund treading on each other's turf.

First, Carlyle itself has just announced plans to launch two hedge funds later this year. And New York-based Blackstone Group LP, which manages the world's biggest buyout fund, has already set up a hedge-fund unit that oversees about $9bn in assets.

Meanwhile, Carl Icahn, a legendary Wall Street raider, is launching his own hedge fund.

The $3.25bn offer

Next, hedge funds are now acting more like buyout firms. For example, Circuit City Stores, America's number two electronics retailer, last month received a $3.25bn takeover offer from Boston-based Highfields Capital Management, which manages hedge funds.

Likewise, Beverly Enterprises, a nursing-home chain, last month rejected a bid worth $1.41bn from an investor group that included hedge fund Appaloosa Management.

Buying out whole companies because you think they are undervalued? That's the kind of work that used to be done by private-equity firms.

So how real is the convergence story?

Traditionally, hedge funds and private-equity firms have been seen as deadly rivals. They compete in two main ways. They joust for talent. Any bright 20-something in the financial markets who wants to make a lot of money quickly (and that covers maybe 99% of them) faces a simple choice: work in hedge funds or in private equity. One of the tasks for both industries is to bring those people with their ideas on board.

Alternative investments

And they compete for money. Most mainstream investors put the bulk of their capital into equities and bonds. They have a small amount allocated to a box marked "alternative investments" for which they are willing to accept higher risk for bigger returns.

Both hedge fund and private-equity managers are chasing that same pool of footloose capital. Yet the rivalry is rather like one of those fiercely contested local derbies between football teams from the same town.

The competition is intense precisely because they are, in reality, playing on the same turf.

The two types of fund are now turning into one another. Both have always, at root, been about the same thing: using financial engineering intelligently in the hope of generating returns higher than anything available from mainstream investments.

Sometimes it works and sometimes it doesn't. The plan is much the same.

20% fees

In time, hedge funds and private-equity firms may end up being the same thing. Some already are. In February, the Financial Times reported that New York-based private-equity firm AEA Investors LLC plans to merge with Aetos Capital LLC, a real-estate and hedge fund firm.

One of the key features of hedge funds is that they don't accept any artificial boundaries on their investments. If they see a profit, they pursue it. A hedge fund won't stop and say: "No, we can't do this because, even though it might make us some big bucks, that's not what hedge funds do." That would go against all their best instincts.

Meanwhile, for the private-equity managers, a hedge fund has a more flexible financial structure and more freedom in the kind of investments it makes. And it generates higher fees, typically 20% of any gains made. (Not that the private-equity firms were ever slouches at paying themselves.)

Three trends

That's why we should expect to see three trends in the year ahead: more mergers between hedge and private-equity funds; more private-equity firms launching hedge funds; and more hedge funds acting like buyout funds. The result? A new breed of alternative investment, probably with the structure of a hedge fund, yet looking more like a buyout fund.

What's the risk profile of Mega-Hedge-Buyouts LLP? Don't even ask. No doubt, some regulators are already chewing their fingernails at the thought of the havoc that might be wreaked if one of them goes wrong.

Still, it will be a fun outfit to work for. And along the way, a lot of smart people will make a lot of money.