Firstly, they are all similar in that they are investment vehicles. Generally, people with excess sums of money (usually very large amounts) will give their money to other investment managers (much the same way as with a mutual fund) and allow them to earn an attractive rate of return on their investment for them. Take these explanations with a grain of salt, as many firms and investment strategies have begun to overlap a bit as they've expanded.
Now, onto the differences...
Hedge Funds
Hedge Funds were first named this since the investments the managers made were typically "hedged", meaning that the investment was protected with some offsetting gain if the original investment decreased in value. Nowadays, hedge fund is much more of a catch-all term for investment funds that employ skilled managers using many different techniques to make positive returns. Most often, hedge funds are engaged in the active trading of readily available and liquid (easy to buy or sell) securities and instruments (such as stocks, bonds, currencies, commodities, options,...etc). The use of computer models employing advanced statistical and stochastic math is also very common.
Private Equity
Private equity is engaged in exactly what it sounds like: taking private equity (ownership) and a business or other enterprise in order to earn an attractive rate of return. There are several strategies that private equity firms engage in. A widely publicized strategy is known as a leveraged buyout. This means that the firm takes on large amounts of debt in order to buy a company or business, and pledges the assets of that business as collateral on the debt. In this way its possible to make larger purchases and to amplify the gains made (leverage will be discussed in more depth later). What is done from there can be anything from financial wizardry (such as restructuring debt, taking on more debt, recapitalizing the firm) to operational and strategic improvements, to capturing synergy gains through acquisitions.
Venture Capital
Venture capital is something that you may have heard about during the tech boom of the late 90s. Essentially, venture capital investing is having an outside investor give a start-up company money in exchange for partial ownership of the company. Venture capital is a very institutionalize way of doing this, as opposed to angel investors, who are often lone individuals who invest in start-ups. Venture capital firms invest in many stages of a start-ups life cycle, from seed money to get started at the beginning, to 2nd and 3rd rounds that start-ups use to grow (and continue operations if it isn't generating cash yet).
Venture capitalists typically invest relatively small amounts (relative to private equity) in a large number of companies for a few reasons. Firstly, they are investing in small companies that may not have very much value. Secondly, they take minority stakes in companies (something on the order of 5%-25%). And lastly, venture capitalists are swinging for the fences: for every 10 Netscapes or Geocities, all they need is one Google, or one Facebook, to net them a hefty return. This sort of investing is rife with large amounts of what is called "option value" (to be explained in another post).
So why do people invest in these things?
Once again, there are a number of reasons that investors give over huge amounts of money to these managers.
- These types of investments have done very well in the past (though there have been down periods, including now) and there is the potential for enormous gains.
- Managers at these investment firms often have their own money at stake, which helps to align incentives (managers make money when investors make money).
- Liquidity, or lack thereof. Most ordinary people don't have the opportunity to take partial ownership of a large company (via private equity) or to invest in start-ups. These are investments that are not easily gotten into or out of.
