What it means
Unlike a mutual fund that anyone can buy into, a private fund sells its interests directly to selected investors under exemptions from public offering rules. Because the investors are assumed to be sophisticated, regulators usually place fewer restrictions on what the fund can do.
The fund is normally set up as a partnership or company, with the manager acting as general partner and the investors as limited partners. Investors commit a set amount, the manager invests it in line with the fund's strategy, and the investors' liability is generally limited to what they put in.
Managers charge a management fee based on the size of the fund, and a performance fee on profits, often subject to a minimum return called a hurdle rate. A common arrangement in the industry is a 2% management fee and a 20% performance fee, but terms vary widely.
Liquidity is limited. Investors may only be able to withdraw at set dates or not at all until the fund winds up, and valuations depend on the manager's estimates for assets that do not trade daily.
These funds suit investors who can accept long lock-ups and want exposure to strategies that are not available publicly. They require careful review of the strategy, fees, the manager's track record and the legal terms before committing.
Reporting is also less frequent than for public funds. Investors typically receive quarterly or annual statements and audited accounts, so they should ask how often assets are valued, who checks the numbers and how conflicts of interest are handled.
In practice
Real-world examples.
Example
A pension scheme invests $25,000,000 in a private equity fund that buys mid-sized manufacturers. The money is called in stages and returned over about ten years. The scheme treats the investment as long-term and cannot sell it early, so it plans its cash needs from other assets.
Example
A wealthy entrepreneur puts $1,000,000 into a hedge fund that trades currencies. The fund allows withdrawals only at the end of each quarter with 60 days' notice. He accepts this restriction in exchange for access to the manager's strategy. The notice period lets the manager sell positions in an orderly way instead of in a hurry.
Example
A university endowment commits to a venture capital fund that backs early-stage technology start-ups. Most of the companies will fail but a few may return many times their cost. The endowment looks at the fund's total returns over the full life of the fund, not year by year, because early years often show losses while the companies are still growing.
Formula
Calculation
Net profit to investors = gross profit - management fee - performance fee
Performance fee = performance fee rate x (gross profit - management fee)
Suppose investors commit $100,000,000 and the fund earns a gross profit of $20,000,000 in a year. The management fee is 2% of $100,000,000 = $2,000,000.
Profit after the management fee = 20,000,000 - 2,000,000 = $18,000,000.
Performance fee at 20% = 0.20 x 18,000,000 = $3,600,000.
Net profit to investors = 18,000,000 - 3,600,000 = $14,400,000, a net return of 14,400,000 / 100,000,000 = 14.4%, compared with a gross return of 20%.Case study
Seen in the real world.
Fairhaven Partners is an illustrative, fictional manager that launched a $60,000,000 private fund investing in small supermarkets. Its twelve investors included a family office, two pension schemes and several individuals.
The fund charged a 1.5% management fee and a 20% performance fee on profits after that fee. In its second year, the fund earned a gross profit of $9,000,000, so investors checked the fee statement carefully.
The management fee was 1.5% x $60,000,000 = $900,000, and the performance fee was 20% of the profit after the fee, $8,100,000, or $1,620,000. In this illustrative story, investors received $6,480,000, a net return of 10.8%, and the clear fee statement helped the manager raise a second fund.
Watch out
Common mistakes.
- Comparing gross fund returns with returns on public funds, when fees and performance charges can take a large share of the gain.
- Forgetting lock-up periods and assuming money can be withdrawn at any time.
- Relying on the manager's valuation of illiquid assets without checking how and by whom it is verified, since a smooth reported return can hide large swings in true value.
Questions
People also ask.
Who can invest in a private investment fund?
Mostly institutions and individuals who meet wealth or experience requirements set by regulators, which differ by country.
What is a hurdle rate?
A minimum return that the fund must exceed before the manager can take a performance fee, which protects investors from paying for returns that a simple bank deposit could have delivered.
How is a private fund different from a mutual fund?
A mutual fund is offered to the public with daily pricing and strict rules on diversification and disclosure, while a private fund is offered to selected investors with fewer rules, more concentrated positions and less frequent redemptions.
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