The overwhelmingly major share of investments in private equity and hedge funds are those of high income individuals and corporates, who have a high apetite for risk and therefore demands higher returns. Since they manage assets of mostly private individuals and institutions, these funds and firms are outside the net of regular financial sector regulation. Further, they are not subjected to the short time horizon pressures of equity markets and the detailed disclosure requirements of the publicly listed companies. Further, unlike public listed firms, these firms can gear up the balance sheets of the companies they buy with many times more debt.
Private equity firms and hedge funds have a serious problem with their image and reputations. They have been bedevilled by serious accusations of asset stripping, selling off assets for a fast buck, unconsiderate and ruthless lay-offs and lack of concern for the welfare of employees, heavy and unsustainable leveraging so as to maximize immediate returns, and no commitment to build up long-term relationships for the firm.
But the most damaging allegations relate to unjustly benefitting from certain anachronistic tax provisions. This tax provision defines fund managers' fees as capital gains, thereby entitling them for the lower taxes (15% as opposed to 35% on the regular income of ordinary Americans) charged on capital gains. The fund manager's share of the funds profit, "carried interest", is treated as a capital gain on invesment rather than as income from employment. This concession is ironical since these managers earn income by playing around with other people's money, leveraged many times over, and only risking a miniscule share of proprietary capital. Further, given their massive leverage ratios, these firms also capitalize from the tax breaks given to interest payments on debt.
Hedge fund managers gets a fee of 2% of funds under management, plus 20% of whatever the fund earns. Private equity firms take home the major portion of the returns from their investments. In the former, the incomes come from palying around with other people's capital, and in the latter it comes from both other people's capital and the massive debts raised. Paul Krugman writing in the New York Times therefore describes them thus,
"Except for the fact that he might make a billion dollars a year, he resembles a waitress whose income dependes on a mix of wages and tips, or a salesman who lives on a mix of salary and commissions, more than he resembles an entrepreneur who sinks his life savings into a new business. Fund managers do not put their own assets on the line."
In the extremely competitive global fiancial markets, with fast diminishing margins, private equity and hedge fund managers have been spectacularly successful in locating and squeezing out every available profit opportunity. The successes of private equity firms like Blackstone, Carlyle, Kohlberg Kravis Roberts (KKR), Texas Pacific Group, and Cereberus Group stand testimony to their impressive performance. These managers thrive by hiving off loss making sections, cutting costs ruthlessly, maximizing returns on other assets of the company and working on the more profitable operations of the company.
A major source of profits for hedge fund and private equity firms is the leveraged buy out (LBO) route. Badly run and ailing firms are purchased, and then handed over to professional managers who are experts in restructuring. Such firms are invariably undervalued and often with minimal tinkering they represent great potential for profit opportunities. This often results in massive layoffs and cost cutting as these managers go in for cutting down the huge inefficiencies inherent in such companies. The PE and hedge funds make their profits generally by exiting through Initial Public Offers (IPO) or by selling to other PE firms. In many cases, poorly run and languishing public listed companies are taken private at rock bottom price and restructured and then again taken public.
It can also be safely concluded that the private equity led M&As and LBOs have contributed significantly to the recent stockmarket rally across the globe. Shares of many companies have been boosted by fears and hopes that they could be the next takeover target of private equity firms.
The aforementioned cases represent some form of transfer of resources and profits from the public financial market to the private market. The small retail investors and financial institutions managing pension and other public funds invest their funds in the public equity and bond markets. The private market consisting mainly of hedge funds and private equity firms, generally manage the funds of high net worth individuals and wealthy corporates. In the typical public equity market route, the margins and captured incomes are shared with retail investors. But in case of private equity and hedge fund firms, the profits are captured by a few high net worth individuals and the firms managing their portfolios.
The hedge fund or private equity firm, by being more eneterprising and competitive, skims off the fatter margins which would otherwise have been shared by investors in the public market. We need to acknowledge that in an extremely competitive environment, undervalued and badly run firms are lucrative storehouses of dormant margins. In fact, they are the few remaining high margin opportunities in the financial markets. We are therefore seeing an unmistakable trend of increasing profits for the participants in the private financial market, at the expense of the investors in the public equity markets.
The breadth and depth of the global financial markets have increased impressively in the recent few years. The proliferation of new actors and growing competition has meant that the fat margins have come down. The hitherto plentifully evident opportunities for arbitrage are giving way to the more subtler variants. The high return opportunities are increasingly concealed in complex financial instruments, which are generally out of the reach of the small investors. Ironically enough, as the financial market is becoming ever more efficient, by way of increased competition, lower margins, and newer trading instruments, its participants are experiencing an ever widening gap in returns.
Critics may argue that these complex instruments are risky and hence command high returns. But then the very complexity of these instruments and the need for vast amount of real time information, makes them inherently inaccessible to the vast majority of individual investors. Understanding the risk embedded in these complex instruments and identifying the fast changing profit opportunities require access to real time information and expensive investment advisory or analysts.
To conclude, the rich are increasingly cornering the few remaining high profit opportunities in the global financial markets, leaving the small investors with only the residual crumbs. This will undoubtedly make these high net worth individuals richer still, and make retail investors less well off than they otherwise would have been. And this is increasingly being borne out by statistics.
Update:
In 2006, three hedge fund managers took home more than $1 bn, led by James Simmons who took home $1.7 bn, or 38000 times the average income. The top 25 together made $14 bn. Paul Krugman has more on this in Gilded Once More.
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