Private equity, hedge funds must be understood to be regulated effectively
By Timothy Spangler
In the aftermath of the global financial crisis, much ill-feeling remains towards Wall Street, the investment banks and those individuals who profit from short-term movements in the financial markets. As the crisis has dragged on, more questions are being raised about how the modern financial system actually works. Identifying “who does what” when it comes to complex derivative securities or the take-over of well-established, brand name companies by faceless financiers seems much more difficult today than a generation ago.
Over the last decade, hedge funds and private equity funds have entered the mainstream public consciousness after many years of profitably operating in the arcane shadows of the economy. Although originally developed in the United States, these funds quickly expanded across the Atlantic to establish a base of operation in London. As they become more and more successful, their techniques, tools, and structures rapidly spread to financial centres around the world.
The financial meltdown that commenced in earnest during the autumn of 2008 has led many observers, commentators, and regulators to question more closely what it is that private equity and hedge funds actually do. Many of the concerns that were identified, though, require a deeper understanding of the structure and operation of these funds in order to properly evaluate them. Without this broader context, effective criticism simply isn’t possible.
In a single weekend in October 2011, protesters inspired by the Occupy Wall Street movement held demonstrations in over 900 cities around the world, in an attempt to draw attention to corporate greed and massive cuts in government spending. Images of these protests filled television screens and social media websites for the weeks that followed.Unfortunately, the recent financial crisis was about more than just greed. This is why it has been so difficult to understand precisely what is broken and how it can actually be fixed. But talking about greed, making signs about greed, and chanting slogans about greed is much easier and much more compelling than actually trying to understand the complex web of linkages between monetary policy and asset values, or how best to oversee the complex operations of cross-border financial conglomerates, let alone how nimble, entrepreneurial financial firms such as hedge funds and private equity funds are able to earn the eye-watering profits that they do.
Marching behind a banner that says, “We demand the forgiveness of all debts,” has a certain rhetorical conciseness, even if it is an utterly impossible and unattainable goal.
After two years of Tea Party protests in the United States that tapped into popular anger at excessive government borrowing and spending that appeared fatally out-of-control, the Occupy movement demonstrated that popular anger could also be marshalled by the Left to attack Wall Street and the global financial infrastructure, even if only for a limited period of time.
While the thrust of the Occupy movement was to attempt a critique of the economic superstructure within which we live, the focus of the earlier Tea Party movement was to voice concern over a government that has grown morbidly obese and ineffective on high taxes and incompetent bureaucrats unable to adequately address the mounting problems that the country faces.
These two points are not mutually exclusive.
Americans and Britons were notably quiet in the months after the financial crisis first made itself known in autumn of 2008. Despite the near collapse of many parts of the international financial systems, and unprecedented levels of governmental intervention into Western economies, for many the events on Wall Street and in the City of London were far removed from their day-to-day lives. It took until 2010 for the Tea Party to gain sufficient momentum in the United States to breakthrough into the public consciousness and until 2011 for the Occupy movement to enter the public stage.
Millions of people are angry, and many millions more are simply frustrated. At the beginning of 2012, it was estimated that over 20% of US residential mortgages are under water and almost 15% of Americans use food stamp benefits. Statistics in Britain and other European countries were equally bleak. As their attentions turns to out-of-touch governments and a moneyed elite that they find hard to understand, Americans and Britons and millions of others are beginning to ask questions begin to be asked about a new generation of independent money managers who have established themselves as key players in the financial markets over the past four decades.
Walk down Fifth Avenue or Knightsbridge and it is clear that some people, at least, are still doing very well despite the economic upheaval. As a result, the focus on private equity and hedge funds has intensified. Unfortunately, many people still lack a deeper and more nuanced understanding of these funds really do, and why.
A general public that no longer trusts business and finance will have tremendous difficulties relating to the sponsors and managers of private equity and hedge funds. These individuals operate in niche areas of finance that intersect with traditional investment banking and commercial banking firms, but their mandates differ significantly from stock brokers, securities underwriters, mergers and acquisition (M&A) advisers and mortgage lenders.
The role of investment advisers and fund managers has been an established part of the world of finance for centuries. In that regard, private equity and hedge funds are clearly not unprecedented. Those with money have long recognized that the fact that they amassed significant sums in the past is no guarantee that they have the knowledge and acumen to invest it wisely and effectively in the future. As a result, talented individuals have long established themselves as trusted advisers who can assist in selecting the best use for these pools of capital, which can provide for lucrative investment returns while at the same time seeking to maintain some level of security for the capital.
In fact, since the end of World War II, retail investment funds have replaced direct stock market investments as the most important way in which “Mom and Pop” investors access the securities markets. Known as “mutual funds” in the US, “unit trusts” in the UK, and “UCITS funds” in Europe, these retail funds now comprise an important part of many families retirement savings.
In the simplest terms, private equity and hedge funds can be seen as different species of this same genus of “investment funds.” Unlike retail funds, however, these funds are limited by law to sophisticated, non-retail investors. Uncle Edgar in Topeka or Aunt Edna in Balham is prohibited by their respective governments from putting their savings in these vehicles.
The success of private equity and hedge funds in the last two decades has led to more coverage of their investment activities in the mainstream press. As a result, more questions are now being asked about what they do, how they do it and why they have been largely free from direct regulation in the past.
We are still coming to terms with the events of 2008, and few consensuses exist on either their causes or their long term effects. Given the increased prominence of private equity and hedge funds in recent years, it is unsurprising that critics are now turning their attention to these “alternative” investment funds, and asking a number of direct and detailed questions about their structure and operations.
Too often, however, the drive to further regulate these funds and limit their potential scope of operation is occurring in a vacuum devoid of detailed knowledge of their structure and evolution. The manner in which these funds operate must be clearly understood or else any further regulation will be at best ineffective or at worst counter-productive.
Timothy Spangler is a Partner and Chair of the Investment Funds group in Kaye Scholer’s London and New York offices, where he regularly advises sponsors on the formation, structuring, and negotiation of a wide variety of investment vehicles, as well as on the full spectrum of securities and regulatory issues typically associated with such transactions. He has worked on a wide range of funds, including hedge funds, private equity funds, venture capital funds, funds of funds, and funds investing in particular countries or sectors. He is the author of The Law of Private Investment Funds, the second edition of which is out now.
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Image credits: (1) Occupy London banner, by Neil Cummings (Flickr: Capitalism is crisis) [CC-BY-SA-2.0]. Via Wikimedia Commons; (2) Wall Street, by mjbs. Via iStockphoto.