In a follow-up from Friday’s posting about the potential global financial calamity that might be caused by the seemingly benign pension fund community, we stumbled across this report (also released last week) by the Brussels-based International Trade Union Confederation (ITUC). The report is called “Where the House Always Wins: Private Equity, Hedge Funds and The New Casino Capitalism“.
Look, we’re obviously biased toward private equity and hedge funds. But we’re also sensitive to their impact on other stakeholders. Private equity, by its very nature, will always be a tug-of-war over economic output between the owners of capital and other stakeholders (employees, suppliers, neighbours, NGOs etc.) Given the massive and sudden growth in private equity and hedge funds, there is no doubt these issues will need to be addressed sooner rather than later. In fact, we know of various multi-lateral initiatives tackling these problems right now and we are following them closely.
However, while attempting to make an important contribution to the global debate, this report makes excessive use of fallacies and half-truths that reveal a populist anger over the bigger issues of economic inequality. The resulting potpourri of socio-economic beefs does little to advance a rationale dialogue.
Before cracking the cover, we took a wild guess that these guys weren’t crazy about alternative investments. And since most of you may not be crazy about unions (or reading the report’s 52 pages), we distilled a few of the more outrageous claims below.
To begin with, this excerpt sums of up ITUC’s overall feelings about hedge funds and private equity:
“In what now appears as the early days of the leveraged buy-out boom, private equity and hedge funds were compared to a swarm of locusts. More recently, it has been remarked by some that is an insult to the locusts: the protagonists of financialisation are more like termites. They leave nothing behind to yield new crops but destroy everything on their way. Whether termites or locusts, such comparisons are a clear call for revamping regulation. That call will be echoed in the last chapter of this report.”
The report argues that the primary objective of a hedge fund is actually quite simple:
“…hedge funds are basically investors that try to make a quick buck by speculating in everything possible.”
And the reason for taking a company private is not to increase its value, but to avoid Sarbox:
“fund managers and corporate executives are increasingly eager to take companies from public to private because by doing so they escape the growing number of reporting requirements and corporate governance regulations that followed in the wake of the Enron and WorldCom scandals. Hence, going private really means increasing the privacy of your business.”
The report seems schizophrenic when it comes to several issues. Firstly, it attacks hedge funds for obsessing about short-term results (e.g. “a quick buck”). But then it seems to side with investors as it complains that private equity funds have extended lock-ins:
“The life of a fund is typically up to ten years, in which the limited partners have committed their capital and are unable to retrieve it.”
“Furthermore, they (pensions) and their trustees should be aware of and consider carefully the consequences of the non-liquid nature of these investments…the inefficient nature of private equity markets…of the irregular cash flow characteristics that such investments have…”
Then the report seems to say that investments in private equity will force pensions to take an active role when they should actually remain “neutral”.
“Investing in hedge funds and private equity may furthermore be against the interests and principles of pension funds because it can get them involved in setting individual company policies, hence taking them out of the sphere of making neutral investments.”
But in its list of recommendations, the report clearly states:
“If pension funds do invest in hedge funds, they should take their shareholder responsibilities seriously by attending shareholder meetings, making their voice heard and ensuring that the fund acts in accordance with the principles of the pension fund in all its dealings with companies.”
The report also seems to ignore basic principles of company valuation when it says that private equity firms only care about the short term profitability of their investments:
“…the long-term profitability and value are not the main aim of the buy-out and the firm behind it: that is the returns that can be generated for the fund during the years that it holds the company.”
The report seems to ignore that fact that the investment return for the fund will be based on the exit price and that exit price is determined by the present value of future profits. So private equity funds are actually very much focused on showing how the firm will be profitable in the long term.
ITUC makes liberal use of a tired, decade-old case study (LTCM) to show the systemic dangers of hedge funds. But in case that doesn’t scare the reader enough, it also conjures up Amaranth – which proves nothing more than the fact that a high profile fund can blow-up every 9 years.
“…the American fund Long-Term Capital Management (LTCM) crashed in 1998. Its investors and creditors were only rescued by a bail-out from the US Federal Reserve. In 2006, the hedge fund Amaranth similarly went into liquidation. A pension fund of employees in San Diego reportedly lost US$105 million on this.”
The report is strangely silent on how much San Diego lost on US large cap stocks in, say, 2002.
Naturally, the report claimed that hedge funds were over-levered:
“With general leverage levels of four to five â€“ i.e. meaning that the funds can borrow money to a value of four to five times the value of the actual money they have raised…”
But regular readers may recall this posting about how leverage was indeed on the rise to 200% (not 500%).
The report cites a NY Fed report that the media erroneously and prematurely interpreted as evidence of high correlation. As these three postings showed, that report actually pointed somewhat ironically to low volatility as the reason for this statistical phenomenon.
In their description of private equity, the authors attempt to raise the alarm over the motivations of private equity funds, but actually end up making cogent arguments in favour of private equity:
“…private equity firms generally go for targets that have under-geared balance sheets and space for taking on debt, so that the company can hold the leverage needed to finance both the takeover and recapitalisations for dividend pay-outs. Fund managers moreover look for poorly performing companies that are cheaper than their peers, that seem easy to improve, or where there are possible synergy effects to be gained by matching them with companies already in the fund’s portfolio.”
“Poorly performing companies”…”easy to improve”…”synergy”…Those scoundrels!
In a similar vein, the reports seems to suggest that “so-called alpha” is something bad. But in doing so, it ends up making a point we have actually made often on this website:
“When public equity markets are in a downturn, these funds tend to outperform them. This is because their strategy is based on making so-called â€˜alpha’ returns that are not based on average market performance. But when the public markets are rising, hedge funds find it much more difficult to stand out. Hence, in the last four years investors would have been better off investing in the equity market in long-term positions than investing in hedge funds.”
Later in the report, the authors hold this up as a central reason to avoid hedge funds. (…and, by extension, plow all of their money into equity markets?)
But no anti-hedge fund report is complete without making a case that hedge funds are volatile The claim in this report is relatively weak compared to most:
“…private equity and hedge funds are generally associated with higher levels of risks than most investments…”
Yes. Private equity and hedge funds are generally associated with higher levels of risk – thanks to self-reinforcing nature of reports like this one. But compare the standard deviations of HFRI Index with the S&P 500 and it becomes clear which one has proven its riskiness.
But if You Don’t Believe Us – The Returns Stink!
Apparently realizing that pension committees are likely take their over-the-top arguments with a healthy grain of salt, ITUC throws a Hail Mary by saying the returns of private equity and hedge funds stink anyway.
“Private equity companies generally aim at, indeed promise, returns of above 20 percent per year. They often fail to meet these aims.”
“Don’t believe the hype..private equity has underperformed during the last decades while hedge funds have done so for the last couple of years or more.”
“…if global credit markets should change that day will come even quicker. And if the global economy at the same time weakens more than expected, it might all get very messy very quickly. Buy-outs would lose momentum and 2007 prices would seem exorbitantly high.”
We’re no experts on private equity (although we are aware of academic research suggest there is some manager return persistence in the private equity world). But the reports conclusion that pensions should invest in, say, equities because hedge funds have under-performed the S&P for a few years is like saying they should invest in growth funds, since value has underperformed for the past few years.
“Furthermore, investors also expect hedge funds to out-perform the markets – if they did not do so, there would be no reason to invest in these funds. But for the last four years, as already noted, it is hedge funds that have been out-performed by the equity markets. So the pressure is on hedge funds to deliver.”
The ITUC is perfectly within its right (some might even say responsibility) to provide a counter-balance to relatively unconstrained global capital markets. But the reality is that if hedge funds and private equity funds are “locusts”, then ill-considered knee-jerk government reaction to them is analogous to spraying pesticides to fix the problem. They are a blunt instrument, developed with the best intentions, but whose toxicity may easily lead to dangerous and unintended consequences down the line.
So while this report recommends liberal spraying of Round-up, the best solution is to understand the root causes of this alledged “locust” problem – taking a holistic approach to addressing the growing dissonance between private equity, hedge funds, and other stakeholders.