US President Barack Obama’s call last Thursday for banks benefiting from a public safety net to be barred for “owning, investing in or sponsoring” private equity and hedge funds as part of wider strategy to curb excessive risk-taking by financial institutions that have benefited from public support, could have broad implications for the alternative investment industry well beyond the borders of the US.
By no means all of those prospective implications are negative. But so broad – and in some respects so vague – are Obama’s prescriptions that it’s far from clear what concrete measures they will lead to. For example, what exactly does “sponsor” mean? Will banks be banned from owning or acting as managers of private equity hedge funds, even where this activity is solely conducted on behalf of clients without any risking of the institution’s own proprietary capital?
Clearly proprietary trading by investment banks is in the firing line, but analysts say that any measures to curb this will have to be carefully drafted. The dividing line between trading activities carried out by a financial institution on behalf of its customers and those executed on its own account is not always easy to draw. In any case, banks say their hedge fund-style proprietary trading businesses have shrunk dramatically in the aftermath of the crisis – although that is no guarantee that left to themselves, they will not grow again in the future.
And beyond that is the issue of whether, with the loss of the late Senator Edward Kennedy’s Massachusetts Senate seat to the Republicans and within it the Democrats’ filibuster-proof majority in the upper house, the president will be able to force through legislation that will certainly be opposed fiercely by an industry with plenty of lobbying resources and political clout, and that like the rest of the US business community has just been freed by the Supreme Court to spend freely on political advertising.
“It is to be remembered that these are ‘just’ proposals at this stage and there will no doubt be much arguing and debating in the weeks and months ahead,” says Dr Richard Reid, director of research at the International Centre for Financial Regulation in London. “In essence the president’s proposals aim to restrict proprietary trading and investment at the banks [and] apparently aim to cut altogether proprietary investments and the sponsorship of hedge and private equity funds by banks, with the government also citing potential conflicts of interest issues.
“As these proposals move into the public domain in more detail there is bound to be an acrimonious debate: times have moved on since [the Glass-Steagall Act of 1933] and how to define certain types of banking activity will be a major task. Part of the attraction of the large, complex banks is that they have customers with large complex financing demands. Not the least of the issues could be how to identify what is proprietary trading.
“These statements today have significantly re-kindled the interest in how best to treat the banks in the wake of the financial crisis. The increased uncertainty could further affect banking behaviour and dampen the recovery in credit growth. There may also be issues about competition with other parts of the financial system not subject to the full force of these measures. The coming months are set to see an intensified period of lobbying – on both sides of the Atlantic.”
Perhaps unsurprisingly, Obama’s proposals have won general approval from the French and German governments, although European officials stressed the need for concerted action if changes to the regulation of international financial businesses are to be effective, rather than prompting a fresh round of regulatory arbitrage as institutions seek the most congenial jurisdiction for particular types of business.
The UK minister and financial services veteran Lord Myners was more reserved suggesting that Obama was seeking solutions for specifically American problems rather than a global prescription. George Osborne, who is expected to be chancellor of the exchequer if the Conservative Party wins power in an election later this spring, initially backed similar curbs for the UK but subsequently backtracked, saying his party did not favour a “return to the crude Glass-Steagall separation of retail banking and investment banking.”
The uncertainty about the scope of Obama’s proposals is summed up by the reaction of Andrew Baker, chief executive of the Alternative Investment Management Association, who says: “We look forward to learning further details of the president’s banking proposals, because many of the specifics are not yet clear. Although the proposals could create welcome opportunities for the global hedge fund industry, we are concerned about the possibility of liquidity in markets being reduced and the prime broker relationship being adversely affected.”
Baker reiterates Aima’s message that the issues with risk exposed by the crisis did not come from the hedge fund industry. “The global hedge fund industry offers strong risk controls and has embraced transparency, both to investors and to the supervisory authorities,” he says.
“There is an alignment of interests between investor and manager in our industry that promotes sustainable and successful investment. That is why major institutional investors such as pension funds are increasing their allocations to the industry and why the industry is once again receiving net inflows. With the global hedge fund industry enjoying its best returns for a decade it can look forward to the future with confidence.”
Assuming that Obama’s plan will in fact require banks eventually to get out of the hedge fund and private equity management business, the initiative will complete a reversal of the trend over the past decade for institutions to set up their own hedge fund businesses (often at the insistence of asset managers enviously viewing the freedom and enormous personal rewards available outside the long-only sector) or to buy into outside management businesses.
Many of the latter deals, conducted at or near the peak of an extremely frothy market, have proved at best of moderate value, at worst a disastrous waste of money. To date there’s been little evidence that banks make good hedge fund managers, and episodes like the collapse of the Bear Stearns structured credit funds, which arguably played a significant role in Bear’s ultimate demise, emphasise that the risks in managing alternatives are not only to a bank’s capital.
Still, any divestment of the banking industry’s role in managing private equity and hedge fund businesses will have far-reaching effects. According to a survey by alternative asset information provider Preqin, US banking institutions have raised a total of 60 private equity funds and funds of funds since 2006, with total assets exceeding USD80bn, and are currently seeking to raise a further USD18bn from investors for 18 new funds.
The firm also notes that bank-sponsored funds have USD50bn in private equity dry powder waiting to be deployed on new investments. The banks themselves, says Preqin, account for 5 per cent of US private equity investors by number and per cent by assets. In addition, 16 banks have fund of funds divisions that currently manage USD94bn in private equity investments.
While banks are relatively small direct investors in hedge funds, with less than 1 per cent (about USD10bn) of the total capital from US investors, Preqin says 19 bank-owned fund of hedge funds businesses account for USD180bn in assets, some 16 per cent of all US hedge fund investments. Overall, the firm says, Goldman Sachs and Credit Suisse stand to be most heavily affected in both asset classes, along with Morgan Stanley and Citigroup in private equity and Bank of New York Mellon and J.P. Morgan in hedge funds.
“Although the full implications of Obama’s statement remain unclear, the potential disruption that such widespread reform could bring to the alternatives industry is significant, and could affect hundreds of banking institutions in the US investing in alternatives,” says Preqin spokesman Tim Friedman. “Furthermore, there would be a knock-on effect for the hundreds of investors in funds and funds of funds managed by these firms.
“Although it could be argued that banks are ‘serving their own customers’, and would therefore be exempt, the situation is currently very unclear, with one possible outcome being a widespread spinning out of alternative assets divisions within banks. Whatever role banks had in the financial crisis, one thing is clear: it was not the bank’s ownership of or investment in private equity and hedge funds that caused the problems.”
Poring over Obama’s statement, industry members say that even if a ban on ‘sponsorship’ does not completely bar banks from managing private equity funds, the proposals would certainly prevent institutions from making co-investments alongside their limited partners, which would eliminate the alignment of interests between managers and investors and make it much harder for bank-run private equity funds to attract capital.
