OECD: Locusts are good for the ecosystem

Hedge Fund Regulation 26 Aug 2007

For two organizations with very similar (and highly creative) logos, the Organization for Economic Cooperation & Development (OECD) and the International Trade Union Confederation (ITUC) have strikingly divergent views on the social redemption of hedge funds.

There was a time when “hedge fund” truly referred to a fund that hedged something.  But as the years went by, hedge fund grew to mean any unconstrained private pool of capital.  And today in some circles, hedge fund means basically anyone who allegedly sc**ws-over a trade union.

At least, so said the June report on hedge funds from the ITUC (see related posting, read full report).  While the report was essentially about the rapid growth of private equity funds and the social impact of buying and selling companies, the term hedge fund seemed to make an awful lot of cameos.

The OECD released a report last week on basically the same topic (available here).  As you might guess, it came out decidedly in favor of private equity and hedge funds on the grounds that they contributed positively to corporate governance.  But this report made a careful and helpful distinction between activist hedge funds and all other types of hedge funds.  In fact, the report was even titled: private equity firms and activist hedge funds.

Before the report attempts to define activist hedge fund, it first tries to define hedge funds in general – with mixed results according to the exhibit below:

Conundrums and dichotomies aside, the report goes on to compare private equity funds and their closest cousin on the genealogical tree of alternative investments, activist hedge funds”.  Said the OECD:

It is hard to define the differences between activist hedge funds and private equity and between these investors and other investors.

Any attempt at a clear delineation of activist hedge funds from private equity, and both investment vehicles from other classes of investors such as mutual funds, pension funds, investment banks and commercial banks, can be highly misleading.

The [report’s] Steering Group’s inquiry is focused on those private equity firms and hedge funds that pursue investment strategies that explicitly aim at increasing the value of their pooled capital through active engagement with individual, publicly held companies.

While the report goes to great lengths to define hedge fund as meaning activist hedge funds only, it also shows various parallels between certain other hedge fund strategies and specific types of private equity strategies.

So it seems that several hedge fund strategies have private equity parallels.  But it turns out that activist hedge funds – the ones singled out as the instigators of various social and financial ills – aren’t a very big group after all.  Continues the OECD:

Although there is little to prevent a migration of hedge funds to the activist strategy, the number of activist hedge funds in the global economy is probably only about 100-120 with funds under management of around USD 50 billion (excluding leverage). If all funds pursuing event-driven strategies were to be included, the sum would rise to about USD 200 billion.

After leveling accusations at hedge funds for causing social unrest, organizations such as the International Trade Union Confederation actually have their sites set on the wrong foe.  As we suggested in our commentary on the ITUC’s report earlier this year, governance conflicts arise not from hedge funds, but from the very system used to allocate capital.  In the OECD’s words:

Any addition to the pool of informed and active investors is positive for corporate governance.
(our emphasis).

And what of the alleged short-termism that is often associated with buyers of private companies (whether they be private equity funds, hedge funds, pension plans, strategic investors or wealthy individuals)?

In our analysis of the ITUC report, we took issue with the assertion that private equity investors sacrifice long term company prospects in favour of short term rewards.  We said that short term rewards were almost always based on exit strategies, not on the intervening cash flows.  So convincing the capital markets that a business will be profitable in the long term is, paradoxically, a critical objective of the short term investor.

The OECD had a similar take and even suggested that convincing the capital markets of long term value rested on a private equity firm’s ability to convince only a small sub-set of the market that a firm was positioned for long-term success

Empirical work suggests thatlonger term factors are valued even in markets characterised by short-run behaviour: equity valuations tend to reflect corporate investment activity and price/earnings ratios imply long term considerations of often around 15 years. Research and development (R&D) investments and related innovation strategies are also incorporated quite rapidly into market valuations. Even if investors as a whole might be myopic, the literature indicates that a small pool of active investors looking at long-run prospects are key to market performance even if the same investors will only invest in the company for a limited period.

If you like this kind of stuff, there’s 81 pages more for you to read over breakfast.  But from a hedge fund’s perspective, the report can be boiled down to the following: You can’t define hedge funds. But we know a small sub-set are kinda’ like private equity funds.  And those ones have a positive effect on corporate governance.

So score one for the locusts!

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