Module 2: Private Equity and Hedge Funds Flashcards
Hedge Fund
An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).
Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year.
For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.
Private Equity
Equity capital that is not quoted on a public exchange. Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. Capital for private equity is raised from retail and institutional investors, and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or to strengthen a balance sheet.
The majority of private equity consists of institutional investors and accredited investors who can commit large sums of money for long periods of time. Private equity investments often demand long holding periods to allow for a turnaround of a distressed company or a liquidity event such as an IPO or sale to a public company.
The size of the private equity market has grown steadily since the 1970s. Private equity firms will sometimes pool funds together to take very large public companies private. Many private equity firms conduct what are known as leveraged buyouts (LBOs), where large amounts of debt are issued to fund a large purchase. Private equity firms will then try to improve the financial results and prospects of the company in the hope of reselling the company to another firm or cashing out via an IPO.
Volcker Rule
A federal regulation that prohibits banks from conducting certain investment activities with their own accounts, and limits their ownership of and relationship with hedge funds and private equity funds, also called covered funds. The Volcker Rule’s purpose is to prevent banks from making certain types of speculative investments that contributed to the 2008 financial crisis.
Named after former Federal Reserve Chairman Paul Volcker, the Volcker Rule disallows short-term proprietary trading of securities, derivatives, commodity futures and options on these instruments for banks’ own accounts under the premise that these activities do not benefit banks’ customers. In other words, banks cannot use their own funds to make these types of investments to increase their profits.
Five federal agencies—the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Commodity Futures Trading Commission and the Securities and Exchange Commission—approved the final regulations that make up the Volcker Rule in December 2013. The rules, formally known as section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, went into effect April 1, 2014, with banks’ full compliance required by July 21, 2015.
The rule allows banks to continue market making, underwriting, hedging, trading of government securities, insurance company activities, offering hedge funds and private equity funds, and acting as agents, brokers or custodians. Banks may continue to offer these services to their customers and generate profits from providing these services. However, banks cannot engage in these activities if doing so would create a material conflict of interest, expose the institution to high-risk assets or trading strategies, or generate instability within the bank or within the overall U.S. financial system.
Depending on their size, banks must meet varying levels of reporting requirements to disclose details of their covered trading activities to the government. Larger institutions must implement a program to ensure compliance with the new rules, and their programs will be subject to independent testing and analysis. Smaller institutions are subject to lesser compliance and reporting requirements.
Proprietary Trading
When a firm trades for direct gain instead of commission dollars. Essentially, the firm has decided to profit from the market rather than from commissions from processing trades.
Firms that engage in proprietary trading believe that they have a competitive advantage that will enable them to earn excess returns.
Prime Brokerage
A special group of services that many brokerages give to special clients. The services provided under prime brokering are securities lending, leveraged trade executions, and cash management, among other things. Prime brokerage services are provided by most of the large brokers, such as Goldman Sachs, Paine Webber, and Morgan Stanley Dean Witter.
Hedge funds were what started the prime brokerage option. Hedge funds place large trades and need special attention from brokerages.
Carried Interest
A share of any profits that the general partners of private equity and hedge funds receive as compensation, despite not contributing any initial funds. This method of compensation seeks to motivate the general partner (fund manager) to work toward improving the fund’s performance.
Traditionally, the amount of carried interest comes out to around 20-25% of the fund’s annual profit. While all funds tend to have a small management fee, the management fee is meant to only cover the costs of managing the fund, with the exception of compensating the fund manager.
Carried interest is meant to serve as the primary source of income for the general partner. However, the general partner must ensure that all the initial capital that the limited partners contribute is returned along with some previously agreed upon rate of return.
Shadow Banking
The financial intermediaries involved in facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions.
Examples of intermediaries not subject to regulation include hedge funds, unlisted derivatives and other unlisted instruments. Examples of unregulated activities by regulated institutions include credit default swaps.
The shadow banking system has escaped regulation primarily because it did not accept traditional bank deposits. As a result, many of the institutions and instruments were able to employ higher market, credit and liquidity risks, and did not have capital requirements commensurate with those risks. Subsequent to the subprime meltdown in 2008, the activities of the shadow banking system came under increasing scrutiny and regulations.
