Alex Lykken February 12, 2014
Timothy Spangler, a law professor at UCLA and frequent contributor to Forbes, has a new book out (“One Step Ahead: Private Equity and Hedge Funds After the Global Financial Crisis“) that lays the groundwork for understanding the private equity and hedge fund landscapes following the 2008 financial crisis. Spangler has been quoted by The Wall Street Journal, The New York Times, The Economist and now, most impressively, by the PitchBook Blog. Below is a quick Q&A with Spangler, who touches on recent regulation changes to the private equity and hedge fund industries and their futures in the post-crisis economy.
Q: What role, if any, did private equity firms and hedge fund investors play in the 2008 financial crisis?
A: Academic research is fairly clear now that although these funds were active in many of the corners of the market that were at “ground zero” of the global financial crisis, neither were a direct causality of the crisis. The key drivers of the crisis, and the culpability as well, appears to lie primarily with government policies that promoted home ownership far in excess of what was prudent, as well as credit rating agencies that “dropped the ball” when it came to their responsibilities in validating the quality of debt instruments. From there, Wall Street investment banks did what they are designed to do for their clients and shareholders—maximize profits by identifying and arbitraging opportunities in the market.
By comparison, private equity funds using debt in their acquisition structures and hedge funds trading in credit default swaps played tangential roles.
Do you subscribe to the argument that the massive amount of debt loaded onto portfolio companies during the buyout boom (2006-2008) poses a problem for the larger economy? In other words, does private equity pose systemic risk to the overall economy?
No, I don’t believe that private equity funds and their use of leverage in the structuring of their acquisitions poses systemic risk. What is important to recall is that there are not the linkages between portfolio companies among various private equity funds—or even linkages between portfolio companies in the same private equity funds—sufficient to induce a widespread banking system failure simply because a handful of the loans (or even a large percentage of the loans) become nonperforming.
The risks posed by banks are far greater, since banks play a much wider role in the overall economy. The priority for financial regulators looking to maintain the stability of the financial system is bank solvency, not private equity funds.
Europe and the United States are both reeling from financial downturns, and have turned to increased regulation as a partial solution going forward. Are there significant differences between the approaches of U.S. regulators versus E.U. regulators concerning alternative asset management? Is one more effective or burdensome than the other?
Overall, the European regulators take a more principled basis when regulating, while the U.S. has more of a check-the-box approach. Both regulators were keen to use the global financial crisis as an opportunity to significantly increase their regulatory reach. And in that regard, they were successful. Dodd-Frank and AIFMD (Alternative Investment Fund Managers Directive) were both signification extensions of rules and regulations covering hedge funds and private equity funds, even though they weren’t the causes of the financial crisis. AIFMD went further than Dodd-Frank in its regulation, but both focused almost exclusively on the fund managers, rather than the funds. Even at this high-water mark of regulation, which will likely not be exceeded in the next few decades, European and American regulators still have relatively little direct authority over the private funds themselves.
We’ve already seen some adjustments from investment banks following the passage of the Volcker Rule(divestments of PE divisions to secondary firms, proprietary traders leaving large banks to join hedge funds, etc.). Donning your prognosticator cap, how different does the private equity and hedge fund landscape look three to five years from now because of these new regulations?
Invariably, the question becomes,”in order to pursue a particular investment strategy, how do we connect people with money and no talent, with people with talent and no money?” Nothing about Dodd-Frank or the Volcker Rule or any of the significant international reforms changes the basic fact that investment talent is both rare and valuable. Since “buying” that talent (i.e. paying an individual so as to employ him on an exclusive basis for only one client) remains prohibitively expensive, private equity and hedge funds will continue to be a convenient and effective way in which to pool would-be clients together into vehicles that provide the managers with sufficient assets to manage and the investors with enticing returns.
Featured image is courtesy of Wikimedia Commons user Alex Proimos.
Timothy Spangler is a writer, commentator, lawyer and academic who divides his time between Southern California and the United Kingdom. He is also the author of the recent book “One Step Ahead: Hedge Funds and Private Equity Funds after the Global Financial Crisis” (Oneworld, 2013). He writes the award winning blog, “Law of the Market,” dedicated to covering the politics of Wall Street regulation and the regulation of Wall Street politics (lawofthemarket.com and @lawofthemarket).