Hedge funds and private markets

In 1998 the hedge fund Long-Term Capital Management held positions worth about 25 times its own capital. At that leverage, a 4% fall in its assets would wipe it out. Within weeks of Russia's debt default, it nearly was, and the Federal Reserve Bank of New York gathered its lenders to take it over.

Mutual funds and ETFs (L1.2.04) are built for the public, so their rules are strict: limited borrowing, daily dealing, wide diversification. Hedge funds and private market funds are built for professional investors such as pension funds, endowments and wealthy families. In exchange for fewer protections, they can do much more.

Hedge funds. A hedge fundA lightly restricted pooled fund for professional and wealthy investors that can borrow, sell short and use derivatives. can sell shortSelling a borrowed security in the hope of buying it back cheaper later., use derivatives, and use leverageUsing borrowed money (or derivatives) so that a fund controls more assets than its own capital.. The name comes from the first such fund, which “hedged” its bets on some shares by selling others short. Today many do not hedge much at all. Traditionally they charged “2 and 20”: a 2% yearly management fee plus 20% of profits, though average fees have come down.

Leverage, in plain words. Buy a house for 100 with 20 of your own money and 80 borrowed. If the price rises 10%, your 20 becomes 30: a 50% gain. If it falls 20%, your 20 is gone (-100%). Leverage multiplies results in both directions, and the lender gets paid first.

Private equity. Private equityFunds that buy whole companies, or large stakes in them, that are not listed on a stock exchange. (PE) funds buy companies, improve them, and sell them, usually over three to seven years. The best-known deal is the leveraged buyoutBuying a company with a large share of borrowed money, repaid from the company's own cash flow. (LBO): the fund pays for a company partly with debt, which the company itself then repays from its cash flow. Venture capital, which backs young start-ups, is the same model at the other end of a company's life.

A PE fund is a partnership. The manager is the general partnerGeneral partner: the firm that runs a private fund and makes its decisions. (GP). Investors are limited partnersLimited partner: an investor in a private fund, such as a pension fund or endowment. Its loss is limited to what it commits. (LPs): they promise, or commit, a sum at the start, and hand it over only when the GP makes a capital callA request from the general partner for investors to pay in part of the money they committed.. The GP earns a management fee plus carried interestCarried interest: the general partner's share of a fund's profits, often 20%., its share of the profits.

Private credit. Private creditLoans made directly by funds to companies, mostly mid-sized ones, rather than by banks or through bonds. funds lend directly to companies, mostly mid-sized ones, often to back PE buyouts. After the 2008 crisis, tougher capital rules made some of this lending less attractive for banks, and funds filled the gap. The loans usually pay a floating rate and are held to maturity rather than traded. The market has grown to well over a trillion US dollars, spread across the US, Europe and Asia-Pacific.

Where the risks sit. Leverage turns small losses into large ones. Private assets are illiquid: they cannot be sold quickly, and their values are estimates made a few times a year, which can hide losses. And because these funds borrow from banks and prime brokers (L1.2.02), a large fund in trouble can pass its losses on to the banking system.

Leverage $L$ is assets divided by equity. Let $r_A$ be the return on the assets and $r_D$ the interest rate on the borrowing, both over the same period.

From the result, two lines tell you when the equity is wiped out (a return of −100%):

At 3× leverage, a 5% asset return borrowed at 4% gives the equity 7%. Flip the asset return to -5% and the equity loses 23%. Now raise leverage towards 25× and watch the line steepen until small moves wipe out the fund.

A PE fund buys a company for $1,000m, paying $400m of its LPs' money and borrowing $600m at 8% a year. The company's cash flow pays the interest and repays $30m of debt each year. After 5 years the fund sells. Amounts are in US$ millions; returns are annualised with yearly compounding (L1.2.04).

Hedge funds and private funds are regulated mostly through their managers, and through rules on who may invest, rather than through limits on what the funds may hold.

• United States: since the Dodd-Frank Act, most advisers to private funds register with the SEC and report on their funds, including leverage, on Form PF.
• European Union: the Alternative Investment Fund Managers Directive (AIFMD) licenses managers, requires a depositary and leverage reporting, and lets supervisors cap leverage. A 2024 revision adds rules for funds that make loans.
• United Kingdom and Asia-Pacific: the FCA, Hong Kong's SFC, the Monetary Authority of Singapore and Japan's FSA license fund managers and restrict sales to professional investors.
• Global: the Financial Stability Board (L1.2.09) watches leverage outside banks, and Basel rules make banks hold capital against their lending to funds.

Looking ahead: counterparty risk on prime brokerage and the wider risks of non-bank finance return in later levels.

• Hedge funds and private funds serve professional investors and can borrow, sell short and hold illiquid assets.
• With leverage L, the equity return is L × r_A − (L − 1) × r_D; a fall of about 1/L in the assets wipes out the equity.
• Common hedge fund strategies: long/short equity, global macro, event-driven, relative value and managed futures.
• Private equity funds are partnerships: LPs commit money, the GP calls it, buys companies (often with debt), and takes carried interest.
• Private credit funds lend directly to companies and have grown as banks pulled back after 2008.

Hedge fund

A lightly restricted pooled fund for professional and wealthy investors that can borrow, sell short and use derivatives.

Leverage

Using borrowed money (or derivatives) so that a fund controls more assets than its own capital.

Short selling

Selling a borrowed security in the hope of buying it back cheaper later.

Private equity

Funds that buy whole companies, or large stakes in them, that are not listed on a stock exchange.

Leveraged buyout

Buying a company with a large share of borrowed money, repaid from the company's own cash flow.

General partner (GP)

General partner: the firm that runs a private fund and makes its decisions.

Limited partner (LP)

Limited partner: an investor in a private fund, such as a pension fund or endowment. Its loss is limited to what it commits.

Capital call

A request from the general partner for investors to pay in part of the money they committed.

Carried interest

Carried interest: the general partner's share of a fund's profits, often 20%.

J-curve

The pattern of a private fund's returns: negative in early years (fees, no exits yet), then rising.

Private credit

Loans made directly by funds to companies, mostly mid-sized ones, rather than by banks or through bonds.

Multiple

Money returned divided by money invested. 2× means you doubled your money.