#2 The Rise of Private Funds: Private equity, venture capital, and hedge funds

Welcome to the second edition of The Daily Concept. If you didn’t get the chance to read the first edition, where I introduced the rationale behind the newsletter, check it out here.

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Your faithful writer, Dan

What are Private Funds? And why does the SEC want to regulate them?

We’ve all heard of ‘hedge funds’ and ‘private equity’ firms, but most people who don’t work in the financial services industry might struggle to explain what distinguishes these kinds of firms from banks or other asset managers.

Hedge funds and private equity funds are part of the “private funds industry,” which has come into the crosshairs of the Securities and Exchange Commission (SEC) in recent years. The private funds industry has grown nearly 3x over the last decade, and the total assets under management (AUM) of private funds surpassed that of banks in early 2021.

Because private funds only invest for wealthy individuals and institutional investors, critics argue that their growth has limited the investing opportunities available to normal Americans. Private equity and private debt markets were already raising more money annually than public stock and bond markets were before the pandemic. In 2017, Former SEC Chair Jay Clayton warned that the growth of private funds was leading to "fewer investment opportunities for Main Street investors.” While rising interest rates have hurt the industry over the past year, it is clear that the size and influence of private funds will continue to grow.

Earlier this year, the SEC announced that it would enact new regulations to increase transparency within the private funds industry. Currently, these funds don’t have to adhere to the financial reporting rules that most investment managers are obligated to comply with. Under the new rules:

• private equity funds and hedge funds must provide clients and regulators with quarterly statements and annual audits.

• private funds and their managers will be more liable in instances of mismanagement or negligence.

• funds will be limited in their ability to offer better terms to some investors.

Private funds are investment funds that don’t solicit money from retail investors or the general public. Typical clients include wealthy individuals, family offices, or institutional investors like pension funds or university endowment funds. Private funds typically promise higher returns than investors might find in public markets by pursuing sophisticated trading strategies (in the case of hedge funds) or by investing in private companies or other illiquid assets (in the case of private equity). Venture capital funds are another popular form of private fund.

Here are some basic definitions:

1. Private equity funds invest in private companies or acquire substantial stakes in existing private companies with the goal of restructuring and growing companies, improving their operational and financial performance, and selling them for a profit. The investment horizon for private equity funds is typically longer-term, often spanning several years, before exiting the investment to realize profits.

2. Hedge funds make money through speculative trading in public financial markets like the stock, bond, and derivatives markets. They are typically managed aggressively to achieve higher-than-average returns, often through strategies such as leveraging, short-selling, and derivatives trading. They can invest in a wide range of assets, including stocks, bonds, currencies, and commodities. Hedge funds usually have a broad investment mandate and can take both long and short positions to hedge against market risks.

3. Venture capital funds invest in startups and early-stage companies with high growth potential. Venture funds typically take equity in the companies in exchange for capital, mentorship, and strategic guidance.

2 & 20: Private funds typically use a “2 and 20” fee structure, whereby they collect an annual management fee of 2% of overall capital. If the firm overperforms an expected return rate, the private fund management will typically collect 20% of profits as a performance bonus.

Learn more about private funds: Critics argue that hedge funds create systemic risk in the financial system by using excessive leverage or by harming companies and investors through short-selling strategies. The private equity industry has received even more criticism in recent years for allegedly hollowing out companies and harming workers. The 2009 NYT documentary Flipped: How Private Equity Dealmakers Can Win While Their Companies Lose is well worth watching for those who want to learn more about the topic.

What’s next: The private equity industry has spoken out in opposition to the regulations and appears to be preparing to take legal action against the SEC to block the implementation of the new rules.

A group of hedge funds established a non-profit called the National Association of Private Fund Managers in Texas, in an area that is under the jurisdiction of a federal appeals court composed primarily of Republican-appointed judges who could back legal challenges to the regulatory changes.

The SEC said it expects a court battle over the rules, with one agency official saying: "There's a whiff of litigation in the air."

ART OF THE DAY

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Yours,
Dan