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Hedge funds, venture capital, and private equity

Similarities in compensation structure for hedge funds, venture capital firms, and private equity investors. Created by Sal Khan.

Video transcript

One thing I probably should make clear is that this idea of getting a 2% management fee and then participating in the profits at around 20%, getting this 20% carried interest, this isn't unique to hedge funds. This is actually the same compensation structure that you'll normally have at a venture capital fund or a private equity fund. And just to be clear, venture capital really is a form of private equity. But normally when someone says private equity, they're not talking about venture capital in particular. In all of these situations, the managers will get roughly 2% for managing the fund and they'll get 20% of the profits. The only difference really, in terms of how it's structured, in a venture capital or private equity fund will still have kind of a limited partnership for the actual fund. And then they would have a management company that gets the management fees and the profits. The only difference is because a hedge fund, for the most part, is probably going to invest in public securities, it could get the money right from the get-go and put that money to work because it tends to invest in fairly liquid assets. So this is fairly liquid assets that they can just go out and buy. So a hedge fund will normally just take as much money as it needs to invest right from the beginning. A venture capital firm or a private equity firm, what they'll do is they'll say, look, I'm going to raise $100 million fund, but I'm not going to be able to just go out the door tomorrow and invest $100 million. In the case of a venture capital firm, they're going to have to look at business plans and entrepreneurs and do their due diligence. Same thing for a private equity firm. They're going to have to look for companies that they might want to buy private equity. You're normally talking about more mature companies that maybe this firm thinks that they can buy and turn around. Maybe more mature companies that need some money to grow really fast. Venture capital tends to be investing in some guys and a business plan or maybe these smaller kind of more, I guess we should call it, more risky companies. But in either of these situations, they won't just find them tomorrow. So what they do is they go to their investors and they get their investors to commit a certain amount of money, to say commit $100 million. And they'll get the management fee on what those investors commit. But they won't take the money right then and there. They'll take the money as they need it. They'll do what's called a capital call to their investors saying, hey, I just found a good $5 million investment. I now need this percentage of what you committed to so that I can go out and make the investment in the hedge fund. That's not the case. All of it is up front. But it really is the same compensation scheme. And that's why if you go to any fancy business school, you'll find these are kind of the careers that, at least the people who are interested in-- I don't want to give them any kind of characteristics-- there's a bunch of reasons why people would want to go into these. But these are definitely sought after careers at a lot of fancy business schools.