Jeremy Warner: Hands off our hedge funds, protection for private equity

Date: Friday, May 1, 2009

Outlook Once again, I find myself having to perform the unenviable task of defending the hedge fund and private equity industries. Populism nearly always makes for bad policy, and by pandering to the "locust" hating politicians of Paris and Berlin, the European Commission seems to be falling into just such a trap.

The proposed European directive on hedge fund and private equity regulation is a financially illiterate dog's dinner of the oppressive and protectionist which flies in the face of the principle of subsidiarity and promises further to undermine the City's position as one of the world's leading financial centres. Financiers are resigned to a backlash, but this is regulatory over-reaction gone mad. Drawn up without consultation, it doesn't deserve even to see the light of day, let alone be passed into law.

Alarmingly, there is every chance that it will, as the directive requires no more than majority support in Europe, and among member states only Britain has a private equity and hedge fund industry of any size to defend. Others regard these activities with suspicion, loathing or complete disregard. They are not likely to come riding to London's defence.

It may be wrong-headed, but hedgies and private equiteers are widely blamed on the Continent for the credit crisis. This is not altogether surprising. They seemed to personify the excesses of leverage and pay that defined the boom in financial services better than any. Many of them were also experts and innovators in the exotic credit instruments and structures that brought the system down.

With their Anglo-Saxon approach to value extraction, they posed a threat to the corporatist contract that exists between state and business in large parts of the Continent. In France and Germany, they are seen not as wealth creators, but parasitic, asset-stripping speculators.

The credit crisis has given the political elite of these countries the opportunity to say: "We told you it would end badly, but you wouldn't listen." Well now they are intent on doing something about it.

As ever, the Eurocrats have chosen the wrong target. In truth, the hedgies and private equiteers were never any more than a symptom of the credit bubble, whose true causes lay elsewhere with the banks. No private equity or hedge fund group has yet had to be bailed out by the taxpayer, and nor have any played any more than a cameo part in the wider systemic collapse of banking.

Most of them have managed to pay back their leverage, which was in any case never anywhere near as high as that run by the banking sector. The entire industry put together fails to match the balance sheet size of a single mega-bank, such as Royal Bank of Scotland or Citigroup.

The term "hedge fund" in any case covers a huge variety of different asset targets and investment strategies. There is little that unites them other than remuneration structures and the pursuit of absolute return. Few if any seem to pose a systemic threat.

With their humongous salaries and apparently freewheeling ways, the hedgies may by example have encouraged the banks into ever greater excesses, but they were never any more than fringe players in a bigger drama.

None of this is to say they shouldn't be better regulated. But to transfer the whole process of registration and authorisation from London to Brussels, as the directive proposes, and make authorisation dependent on official blessing for strategy and asset allocation would be extraordinarily harmful to the future of many of these funds and would almost certainly tip quite a few of them into seeking refuge in Zurich and other more hospitable climes.

To guard against this possibility, the directive proposes that no fund managed out of a non-EU country can be sold to European investors unless that country agrees to abide by the same regulatory regime. The directive thus takes on protectionist overtones. The US, the other big centre for hedge funds and private equity outside London, would never agree to such an approach. US-based hedge funds would thereby be banned from selling to European-based institutional investors.

As if all this were not bad enough, the directive seems based on almost total ignorance of the industries it proposes to regulate. For instance, the proposed threshold for private equity funds is $500m provided they aren't leveraged. In fact, hardly any private equity funds are leveraged. Rather the leverage is applied to the companies they invest in.

Likewise, the idea that a hedge fund as small as $100m – the threshold for hedgies – would pose a risk to European stability is laughable.

To add insult to injury, the directive flies in the face of the EU-commissioned de Larosière report on the future of financial regulation, which was relatively considered in its recommendations, and the work the G20 has been carrying out on supervising hedge funds.

Nobody's got much sympathy for hedgies and private equiteers these days. Even if they weren't the cause of the crisis, many of them were symptomatic of the irrational exuberance that allowed it to happen. Yet to close them down entirely, which would be the effect for many of the oppressive standards of authorisation proposed, is not obviously a healthy development. As Lord Turner, the chairman of the FSA, has proposed, those hedge funds and perhaps private equity groups too that behave like banks should be regulated in the same manner, with the same capital requirements and intrusive standards of oversight.

But those that pose no systemic risk, which is the great bulk of them, should be left to their own devices. If Germany wants to ban private equity takeovers and hedge fund activity, then that is Germany's prerogative. Yet there is no reason it should be allowed to impose such politically driven regulation on the rest of us.

Frankfurt and Paris have always resented the success London has achieved as a financial centre. They must not be allowed to use the financial crisis to destroy it.