Hedge Funds and Private Equity Funds

Hedge funds and private equity funds have frequently been regarded as potential sources of systemic risk, given their lack of regulation and reporting requirements, high exposure to international financial markets, high degree of leverage, and, in the case of hedge funds, the high rate of turnover in their portfolios and their reliance on complex investment strategies. In this section, we examine the structure, performance, and role in the current global financial crisis of hedge funds. On the whole, we found that they did not play a significant role in causing the crisis, although selling pressure emanating from them did serve to amplify downward pressure on financial markets at a later stage of the crisis.

A. Hedge Funds

There is no widely agreed-upon definition of hedge funds, and, in fact, many of these funds do not use “hedging” to manage risk. They do, however, share a number of defining characteristics. Most importantly, they are investment funds that accept funds only from very large investors (e.g., in the United States [US], individuals with US$5 million or more in investment assets). This allows them to avoid most, if not all regulations that apply to investment funds catering to smaller investors. For example, hedge funds typically are not required to register with the Securities and Exchange Commission in the US, although United Kingdom (UK)-based funds are required to register with the Financial Services Agency in the UK. Hedge funds typically invest in a broad range of investments, including equities, debt, and commodities; invest in many international markets; and make both long and short investments. They also generally adopt various sophisticated investment strategies using structured products. Hedge funds typically have absolute-return investment targets and fee structures highly geared to those returns, and, most relevantly for financial stability issues, employ leverage to enhance those returns.

Available data on hedge fund assets show that they rapidly rose from about US$324 billion in 1999 to US$2.2 trillion in 2007, an annual average growth rate of 23%. In 2008, the total number of hedge funds fell 9% to about 10,000 (International Financial Services London 2009). The level of assets, however, collapsed to only US$1.5 trillion by the end of 2008, reflecting declines in both market value and redemptions. Moreover, the level could have been even lower, as some hedge funds adopted “lock-up” provisions that temporarily prevented redemptions by their investors.

Perhaps the most counterintuitive finding about hedge funds is that their overall average leverage ratio is not very high, hitting a near-term high of about 190% in 2007, and falling to about 120% in 2008 (McGuire and Tsatsaronis 2008). In contrast, regulated commercial and investment banking institutions had, in some cases, far higher leverage ratios of about 20 times or more. These included Citigroup (19.2 times), Goldman Sachs (28 times) and Morgan Stanley (33 times) (Wall Street Journal 2008).

B. Private Equity Funds

Private equity funds are similar to hedge funds in their structure and regulation. However, they differ substantially from hedge funds in terms of their investment period and investment assets. “Generally, “private equity” refers to a wide range of alternative investments, including equity investments in unquoted companies; venture investing at early and late stages; large-size and mid-size buyout investing; mezzanine debt and mezzanine equity investments; special situations; and finally real estate investments. Private equity also includes privately negotiated investments in public companies. A “private equity fund” refers to a limited partnership in which the general partners invest in private equities on behalf of the fund's limited partners. Private equity funds tend to have a fixed life of 10 to 12 years. The funds are self-liquidating structures; that is, general partners invest the raised funds within three to five years of the inception. As investments are divested, the cash realizations are distributed to the limited partners over time.” (Erturk, Cheung, and Fong 2001) Private equity funds typically take a direct equity stake in companies that they regard as having good long-term prospects. Therefore, unlike hedge funds, their portfolios are quite illiquid and stable from year to year. Like hedge funds, private equity funds typically employ leverage to enhance returns. The degree of leverage varies with market conditions, but, between 2000 and 2005, debt averaged between 59% and 68% of the total purchase price for leveraged buyouts (LBOs) in the US (Trenwith Group 2006).

Funds managed by private equity funds also rose rapidly over the past decade, going from about US$40 billion in 2000 to US$500 billion in 2007, an annual growth rate of 31%, but falling to US$440 billion in 2008 (International Financial Services London 2008). Again, the “equilibrium” amount is likely to be significantly lower, because many investors would have preferred to sell, but were locked into forced contributions when anticipated returns from earlier years did not materialize. Also, in many cases these funds are still sitting on large amounts of cash, since the market for LBOs has collapsed.

Unlike loans to hedge funds, the outstanding amount of leveraged loans issued in connection with LBOs increased slightly to US$600 billion in 2008 (Standard and Poor's 2009). However, this increase largely reflects the long lock-up period for private equity funds. Nonetheless, the share of “covenant-lite” and second lien loans in total loans began to shrink in mid-2007, reflecting tightening credit conditions and reduced appetite for risky loans.

C. Role of Highly Leveraged Funds in the Financial Crisis

Prior to the current global financial crisis, concerns about systemic risk arising from highly leveraged investors centered on two categories—direct losses of core institutions on counterparty exposures to such investors, and indirect losses on banks' trading positions caused by forced liquidation of hedge funds' positions. In fact, however, hedge funds were not a major contributing factor to the start of the current crisis. Of greater significance were the direct losses experienced by internal funds of investment banks and the warehoused assets of banks. Indirect losses attributable to hedge funds started to become an important issue in 2008, when hedge funds became large-scale forced sellers to meet redemption demands by investors in response to the overall decline in financial markets. Thus, the current crisis differs from that of the Long Term Capital Management (LTCM) crisis of 1998, when both direct and indirect losses arising from LTCM's failure were seen as having systemic risk implications. This suggests that regulation of hedge funds and private equity funds is not an urgent issue, although issues of monitoring and regulation need to be considered carefully.

D. Reform Proposals

There is no consensus yet on whether to regulate hedge funds and private equity funds, although most recommendations focus on stepping up monitoring and communication rather than on increasing regulation. The Financial Stability Forum (FSF) released its most recent reports on highly leveraged institutions in May and October of 2007 (Financial Stability Forum 2007a, 2007b). These maintained the stance of not calling for regulation of these entities. Instead, the reports called on authorities to increase their surveillance and monitoring of the risk management activities of core institutions, and called on the hedge fund industry to review and enhance existing sound practice benchmarks for hedge fund managers in the light of expectations for improvement set out by the official and private sectors.

The Basel Committee on Banking Supervision has taken a similar approach, putting most of its emphasis on strengthening guidelines for estimating capital at risk in banks' trading books and making enhancements to the Basel II framework (Basel Committee on Banking Supervision 2009a, 2009b). This is also implied by the conclusions of the so-called de Larosière report issued in February of this year, which is the most recent comprehensive European statement of regulatory recommendations emanating from the current crisis (European Commission 2009b). The report states, for example: “If banks engage in proprietary activities for a significant part of their total activities, much higher capital requirements will be needed.” (European Commission 2009b: 17)

This is consistent with the experience that the activities of the regulated banks themselves were the key factor behind the current crisis. However, the European Commission has indicated that it will publish a “comprehensive legislative instrument establishing regulatory and supervisory standards for hedge funds, private equity and other systemically important market players.” (European Commission 2009a: 7) The Group of Twenty (G20) communiqué of April 2009 noted its agreement “to extend regulation and oversight to all systemically important financial institutions, instruments and markets. This will include, for the first time, systemically important hedge funds.” (Group of Twenty 2009)

The FSF also noted that the issuance of draft best practice standards by the UK-based Hedge Fund Working Group, which include a “comply or explain” expectation, was a notable step toward improved transparency and discipline, and represented a recognition by the sector of its responsibilities as a significant force in the financial system (Hedge Fund Working Group 2008). However, the lack of uptake within the hedge fund industry of these recommended principles has been disappointing, and leaves open the door to regulation imposed from outside.

The approach of regulators to hedge funds is guided by their desire to reduce the procyclicality of the financial system and its tendency to boom and bust. In particular, there are concerns about the feedback loops between bubbles or bubble collapses in asset prices and their impacts on the real economy. To address these concerns, the FSF, in cooperation with the Bank for International Settlements, Basel Committee on Banking Supervision, Committee on the Global Financial System, and other international bodies, is examining ways to mitigate procyclicality. The focus of the study is on capital regulations, loan-loss provisioning, interaction of valuation standards and leverage, and compensation practices. One approach being explored is the use of “through-the-cycle” estimates of asset values. In addition, the group recommends that regulators closely monitor the activities of large hedge funds with a potential for systemic risk and maintain an ongoing dialogue with those firms.

The group also supports the development of a macro-prudential framework to monitor and address the buildup of risk in the financial system. Hedge funds and private equity funds are to be included in the monitoring process. The approach likely to be adopted is similar to that of the UK's Financial Services Authority, which focuses on identifying the potential for systemic risk. Another approach being widely considered is to modify the framework for monetary policy to place more weight on the importance of asset price movements. Nonetheless, further direct regulatory requirements on hedge funds and private equity funds cannot be ruled out.

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