BANKING & FINANCE: Taming the private equity fund “locusts”

The full repercussions of the financial crisis triggered by bad mortgage debts in the United States are still unclear, but what we do know is that its unforeseen effects already include an unstoppable demand for greater transparency in our financial markets, and better regulation.

One part of the financial market not subject to the rules of transparency and disclosure that apply to, say, banks and mutual funds, concerns hedge and private equity funds. These private funds were once relatively small. Rich individuals took on higher-risk investments in innovative and start-up companies. Today, the five biggest private equity deals have involved more money than the annual budgets of Russia and India. Assets in hedge and private equity funds stand at $3 trillion today and are expected to reach $10 trillion by the end of 2010. The funds now rely heavily on investment from pension funds, and on money borrowed from banks and other non-private sources.

These private funds now account for about two-thirds of all new debt. If there is a debt problem, as in the US mortgage crisis, you have to look at the role of the private funds in creating it. They are a threat to financial stability. Unless regulated they are likely to trigger future crises due to their reliance on huge accumulated debt and their lack of transparency.

Financial instability is not some remote danger that does not disturb our lifestyle. Ordinary families’ pension funds, savings and jobs will pay the price in the end.

Then there are other problems not directly connected to the recent financial crisis. Private equity funds are a menace to healthy companies, to workers’ rights and to the European Union’s Lisbon Agenda (aimed at making Europe the world’s most competitive economy). Private equity funds – more than hedge funds – are often involved in “leveraged buy-outs”. In a typical pattern, a company is bought with borrowed money, the company is then saddled with the debt and interest payments, workers are laid off and assets are sold. A once profitable and healthy company is milched for short-term profits – benefiting neither workers, nor the company’s long-term prospects, nor the real economy.

In Britain, the Automobile Association was bought by private equity in 2004. The AA had made a profit of £75m and was providing an expanding service with 10,000 staff. Annual profits have gone up to £190m while 6,000 workers have been laid off, and both costs and waiting times for AA members needing its vehicle repair and recovery services have increased. In Denmark, the TDC telecommunications company was taken over by a group of private equity firms in 2005, with 80% of the purchase financed by borrowing. The company’s assets-to-debt ratio leapt from 18% to 90% as company reserves for long-term development – essential in the telecoms industry – were used to pay the debt!

These funds are largely exempt from paying tax, often because they are registered offshore although of course they have to operate from the world’s major onshore financial centres. One fund manager has admitted that he pays less tax than his cleaning lady. In the US, it has been calculated that the funds involve a tax loss to the country of $2-3bn – three times the EU budget for humanitarian aid. It is only a slight exaggeration to say that hedge and private equity funds represent the opposite of sustainable long-term growth: they are high-risk, high-profit ventures often keyed to short-term gains.

Trade unions in the UK, Germany, Canada and elsewhere have for long spoken of the damage caused by leveraged buy-outs. So have such senior politicians as Germany’s former Vice-Chancellor Franz Müntefering, who described private equity funds as “locusts”, and Barney Frank, chairman of the powerful US House Committee on Financial Services. The European Parliament’s Socialist Group, the House of Commons in the UK and the Australian parliament have all investigated these private funds.

However, Charlie McCreevy, the EU’s internal market commissioner, is staunchly resisting any move towards better control of private equity and hedge funds. But the tide is turning against him.

At the EU’s Autumn summit in Lisbon the three heavyweights of European politics – Gordon Brown, Angela Merkel and Nicolas Sarkozy – agreed in a joint statement that more transparency is needed in financial markets. In a separate move Gordon Brown promised as Britain’s new prime minister to close any tax loopholes that enable hedge fund managers to exempt themselves from tax.

Both the private equity and hedge fund industries have reacted by publishing voluntary codes of practice. Paul Marshall, a hedge fund chairman, told the Financial Times that he hoped a voluntary code of conduct for the industry “will take the pressure off”. At least that was transparent.

It is important to be clear that nobody wants to ban or unnecessarily restrict private equity and hedge funds. These private funds could have a useful role to play: the often-repeated claim of the industry that they use private money to invest in innovative and high-risk new companies. Their critics want to ensure that they honour the transparency and tax rules accepted by everyone else in the financial markets.

Ultimately private funds should be regulated globally. But coordinated action by the European Union and the US would be a realistic start. Private funds cannot operate without those two giant markets, and would have to comply with their requirements. The will to take action exists in the EU. When faced with the leaders of Europe’s three largest economies, Charlie McCreevy is not a serious obstacle. The current occupant of the White House is a more formidable obstacle to reform in the US, but a change is coming.

Leveraged buy-outs cannot be dealt, though, with solely by getting the funds to follow the same rules of transparency and disclosure as everyone else. They would still be objectionable. There are at least two possible solutions; first, set a limit on the amount of debt that a company can accumulate, and, second, change acquisition and merger legislation to include leverage. The latter clearly falls within the competence of the European Union.

Hedge and private equity funds are presenting an unacceptable face of today’s global economy. The will is growing – particularly in the wake of this year’s financial crisis – to bring make these private funds more generally acceptable. There is still a lot of talking to do. Serious discussions are needed at EU level to reach agreed European and inter-governmental actions, and to encourage the US to move in the same direction.

Change is coming, and for the sake of our pensions, our savings and our jobs, the sooner the better.