Hedge funds and private equity

Question 1

What is shorting?

Answer 1

Allows a fund manager to bet on falling prices.

• Borrow the shares (at a cost) from an existing investor
• Sells those shares in the market
• If they have fallen enough to cover costs when they are bought back -> profit

Question 2

What was the historical purpose/origin of the hedge fund?

Answer 2

First established in 1947 by Alfred Winslow Jones, the idea was to go long on one group of shares and short on another group of shares of the same value, thus protecting himself from market movements. His position was hedged. Providing long positions beat short positions -> profit

Question 3

What are the main characteristics of modern hedge funds?

Answer 3

They’re only open to “accredited” or qualified investors: Hedge funds are only allowed to take money from “qualified” investors—individuals with an annual income that exceeds $200,000 for the past two years or a net worth exceeding $1 million, excluding their primary residence. As such, the Securities and Exchange Commission deems qualified investors suitable enough to handle the potential risks that come from a wider investment mandate.

2. They offer wider investment latitude than other funds: A hedge fund’s investment universe is only limited by its mandate. A hedge fund can basically invest in anything—land, real estate, stocks, derivatives, and currencies. Mutual funds, by contrast, have to basically stick to stocks or bonds, and are usually long-only.
3. They often employ leverage: Hedge funds will often use borrowed money to amplify their returns. As we saw during the financial crisis of 2008, leverage can also wipe out hedge funds.
4. Fee structure: Instead of charging an expense ratio only, hedge funds charge both an expense ratio and a performance fee. This fee structure is known as “Two and Twenty”—a 2% asset management fee and then a 20% cut of any gains generated.

Question 4

What is a private equity fund?

Answer 4

Private equity is a source of investment capital from high net worth individuals and institutions for the purpose of investing and acquiring equity ownership in companies.

Normally, funds will take over the entire company, attempt to improve its performance and then sell it (either to the stock market or a corporate buyer). This is usually funded with a lot of debt hence the original name for private equity funds was leveraged buyout funds. OFten the management is incentivized with equity stakes which will make them rich if the value of the company rises sharply.

Question 5

What are the main issues with private equity funds?

Answer 5

• Loading a company with debt is risky (may lead to job losses or cuts in spending in say R&D to limit costs)
• Lack of transparency - since businesses owned by private equity groups are not publicly quoted, they do not receive the same level of scrutiny from outside investors or the media.
• Debt is tax deductible, so highly indebted companies can avoid paying corporation tax. Additionally, partners in private equity funds were allowed to class most of their profits as capital gains rather than as income -> paying much lower taxes.

Question 6

What is capital gains?

Answer 6

Capital gain is an increase in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price. The gain is not realized until the asset is sold. A capital gain may be short-term (one year or less) or long-term (more than one year) and must be claimed on income taxes.