Hedge Funds, Buyout Firms Say Regulation Unstoppable

Date: Friday, March 27, 2009
Author: Katherine Burton and Rebecca Christie, Bloomberg.com

Hedge funds and private-equity firms, after opposing increased federal oversight for years, said they can’t escape the Obama administration’s plan to include them in an overhaul of U.S. financial regulation.

“We’re not going to be able to stand in the way of that speeding train,” David Rubenstein, co-founder of private-equity firm Carlyle Group, said at a conference in New York yesterday.

“New rules of the game” are necessary to restore confidence in the financial system after credit markets seized up and stocks fell the most since the Great Depression, Treasury Secretary Timothy Geithner said yesterday. He proposed requiring hedge funds and private-equity firms to register with the U.S. Securities and Exchange Commission and to disclose information about their holdings.

“The industry has been bracing for the call for regulation and within reasonable bounds accepts it,” Jim Chanos, founder of New York-based Kynikos Associates Ltd. and head of the Coalition of Private Investment Companies, a hedge-fund trade group, said yesterday in a Bloomberg Television interview.

Hedge funds and buyout firms would also fall under the purview of a new regulator that would identify companies deemed “systemically important,” or capable of wreaking havoc on financial markets. Officials would have the authority to seize these firms if they threatened the markets, much as they do now with insolvent banks.

Different Than Banks

Geithner said the administration didn’t intend to regulate all funds like banks, which must adhere to requirements for capital, liquidity and reserves for potential losses.

“In the future, if some of them individually reach the size where they may be systemic, then at that point we believe they should be brought within a regulatory framework that’s similar to that which exists for banks,” Geithner said at a House Financial Services Committee hearing.

He didn’t specify the size at which the investment firms would be considered systemic.

Hedge funds are private pools of capital whose managers can buy or sell any assets, bet on falling as well as rising asset prices and participate substantially in profits from money invested. They managed $1.2 trillion as of Dec. 31, according to Chicago-based Hedge Fund Research Inc.

Regulators, concerned last October that hedge funds were aggravating the decline in financial markets, monitored managers to make sure they wouldn’t endanger counterparties. Citadel Investment Group LLC on Oct. 24 dismissed speculation that declines of about 35 percent in its two biggest funds would force it to liquidate. The funds ended the year with losses of about 55 percent.

Registration Hesitation

The Managed Funds Association, a Washington-based hedge- fund group, said it supports a systemic-risk overseer. It didn’t fully endorse SEC registration.

“There are a great many issues that should be considered in determining what, if any, such framework should look like,” Richard Baker, chief executive officer of the group, said yesterday in testimony before the Senate Banking Committee.

Once registered, the investment firms, including venture capital companies, would have to report information about their trades and counterparties to the SEC. The agency would share the data with the systemic-risk regulator, which could restrict the funds’ reliance on short-term financing and limit how much money they can borrow to maximize trading profits. The disclosures wouldn’t be made public.

More Disclosure

The SEC in 2005 passed a registration rule requiring fund managers to provide information such as their business address and assets under management. The move also opened up their funds to random audits. The rule was thrown out by a federal appeals court in 2006 after it was challenged in a suit by Phillip Goldstein, founder and principal of Bulldog Investors in Saddle Brook, New Jersey.

At the end of 2008, at least 1,804 hedge-fund managers had voluntarily registered with the SEC, or about half the estimated number of hedge-fund firms at the time, according to Hedge Fund Research. Geithner’s plan would require funds to pass on more information than they do now under voluntary registration.

“The good side is that they will have a uniform approach to a very, very difficult problem,” Jack Hewitt, a partner with the law firm McCarter & English LLP in New York who works with hedge funds, said of regulators. “The other side is that they are going to be regulating entities that have historically been regulated in a different manner.”

Less Leverage

The call for greater oversight comes as leaders of the world’s 20 largest developed and emerging economies are set to meet April 2 to devise a common approach to the global financial crisis. Finance chiefs from the G-20 member states said March 14 they would strengthen ties between their individual banking supervisors, and that credit rating companies, hedge funds, off- balance sheet vehicles and credit derivatives markets will be subjected to greater scrutiny.

Only one hedge fund has come close to bringing down the financial system. In 1998, John Meriwether’s Long-Term Capital Management LP destabilized financial markets worldwide and prompted the Federal Reserve to organize a bailout by the fund’s 14 lenders.

The government later determined that it was banks’ responsibility to keep closer tabs on how much money was being lent to hedge funds. Long-Term Capital borrowed $30 for each $1 of investor capital. Hedge funds today are borrowing less than $1 dollar for every dollar of assets, in part because banks have curtailed lending.

While Rubenstein, who runs Washington-based Carlyle, said more regulation was unavoidable, the U.S. private-equity industry’s main trade group said its members don’t pose a systemic risk.

“Private-equity firms invest in companies, not exotic securities and their investors are long-term investors, eliminating the ‘run-on-the-bank’ type of risk that helped create the current financial crisis,” Douglas Lowenstein, president of the Washington-based Private Equity Council, said yesterday in a statement.

To contact the reporters on this story: Katherine Burton in New York at kburton@bloomberg.net; Rebecca Christie in Washington at Rchristie4@bloomberg.net