The Globalization of “Locusts”

By Kavaljit Singh | Commentary | May 30, 2005

In April 2005, Mr. Franz Müntefering, Chairman of the Social Democratic Party (SPD), the dominant party in Germany’s ruling coalition, described private equity funds and hedge funds as “swarms of locusts that fall on companies, stripping them bare before moving on.” He told a German newspaper that “some financial investors don’t waste any thoughts on the people whose jobs they destroy.” Later on, the German press published an internal SPD memo listing a dozen “locusts” (including Goldman Sachs and Kohlberg Kravis Roberts & Co.) whose short-term profit-maximizing strategies have received considerable public criticism. Several commentators discounted the remarks of Mr. Müntefering as part of rabble-rousing campaign on the part of SPD to win the crucial regional elections in its stronghold in North Rhine-Westphalia (Germany’s most populous state) on May 22, 2005. Whatever the narrow political considerations behind Mr. Müntefering remarks were but the issues raised by him are of grave importance and therefore should not brushed aside.

The crushing defeat of SPD in these elections for the first time in the past 39 years was a reflection of the growing public discontent against the paradigm shift towards an Anglo-Saxon style pure market economy. Just a year back, the Schroder government had allowed the hedge funds to operate within the country as part of its wider financial liberalization program initiated in the late 1990s. The Schroder government has come under sharp public criticism for its policies to weaken Germany’s well-established model of social-market economy which is facing global competitive pressures emanating from Asia as well as new EU member-states from Central andEastern Europe. Launched in 2003, the much-touted economic reforms packages such as Agenda 2010 and the Hartz IV have failed to achieve desires results. The prospects of employment generation and economic growth are bleak. There is already a downward pressure on the wages. The unemployment rates are increasing while this year the economic growth is expected to be a mere 0.7 per cent, the lowest in Europe. Since the country is moving towards Anglo-Saxon style market economy, higher unemployment and lower economic growth are likely to persist in the years to come.

The Day of the “Locusts”

Technically speaking, private equity funds and hedge funds are two different financial instruments but over the years their distinct characteristics have become blurred by rapid financial liberalization and globalization processes. Nowadays, they often work in partnership, particularly in corporate restructuring. Under the competitive pressures, most German companies are focusing on their core businesses rather than expanding their businesses. There has been a sharp decline in corporate investments in recent years. Such a scenario provides ample opportunities to equity funds to restructure German companies. It has been estimated that private equity funds have acquired more than 5000 German companies since the late 1990s. Seeking an annual return of above 20 per cent, investments by private equity firms are usually short-term, ranging from one to three years. After taking over companies, equity firms reduce the costs within a short span by firing workers and restructuring the debt. Then the restructured company is sold to new buyers or other equity funds.

On the other hand, hedge funds not only have more capital under control (some 8000 hedge funds manage assets more than US$1 trillion globally), but they also earn much of their profits from speculation and arbitrage activities. Since 2003, the global hedge fund industry has undergone rapid transformation. Unlike the past, hedge funds are no longer the exclusive domain of billionaires and extremely wealthy individuals. Given the low yields in the equity and bond markets, other investors have flocked over to hedge funds as some promise returns up to 40 per cent. Even long-term investors such as pension funds and insurance companies based in the USand Europe have also started investing substantial capital into hedge funds.

The trouble with the hedge funds is the potential risk posed by them to the entire financial system, due to their speculative trading behavior and higher levels of leverage. The hedge fund industry continues to borrow large amount of capital from the banks and financial institutions to enhance returns. This is despite the spectacular collapse of a US-based hedge fund, Long-Term Capital Management (LTCM), in 1998 which was finally rescued under the supervision of the New York Federal Reserve. It seems that lessons from the LTCM episode have not been learnt by hedge fund industry and regulatory authorities. Since the main counterparties to hedge funds in several markets are often the same investment banks and financial institutions, any big loss suffered by a hedge fund could generate a domino effect thereby threatening the solvency of investment banks and financial institutions.

In Germany, the role of hedge funds came under closer scrutiny when the UK-based hedge fund, The Children’s Investment Fund (TCI) brought about management change at Deutsche Borse, the German company that operates the Frankfurt stock exchange. By owning just 8 per cent of Deutsche Borse’s share, the TCI was not only instrumental in ouster of its CEO, Mr. Warner G. Seifert but, more importantly, was successful in blocking Borse’s bid to buy the London Stock Exchange.

The Globalization of Pest Control?

Of late, the phenomenal rise of hedge fund industry has come under considerable criticism in many other parts of the world. Recently, John Sunderland, President of the Confederation of British Industry, attacked hedge funds for their short-term investment strategies and lack of transparency and accountability. For the first time, the UK financial regulatory authority, the Financial Services Authority (FSA), has taken a tough stand against hedge fund industry. This is a significant development given the fact that the bulk of European hedge funds are located in the UK and they account for at least 30 per cent of trading at the London Stock-Exchange, which is the biggest stock market within the Europe. In its latest discussion paper, the FSA has warned that “some hedge funds are testing the boundaries of acceptable practice concerning insider trading and market manipulation.” The FSA has also announced the establishment of a dedicated new unit which would monitor and supervise the trading behavior of hedge fund industry.

In Asia too, the debate on regulating equity funds and hedge funds has, once again, gained momentum. Take the case of South Korea where private equity investors earned billions of dollars by taking over sick banks in the post-crisis period and later re-floating them in the financial markets. Many of such transactions were carried out by such funds without paying any taxes. This led to a big public outcry in Korea and the regulatory authorities have promised actions against such manipulative activities. In India, hedge funds successfully exploited a loophole in the derivative and cash stock markets to reap huge profits and regulatory authorities are devising special measures to curb their activities.

Even in the US, the Securities and Exchange Commission is examining new measures to increase its surveillance on hedge funds.

All these recent developments propel fresh thinking among policy makers, regulatory authorities and political leaders to devise policy measures to deal with the potential threat posed by hedge funds to the financial system as well as the real economy. The financial markets in which these funds operate are not perfect due to asymmetric information, herd behavior and moral hazard. Therefore, the need of the hour is more (not less) regulation and supervision. To begin with, these funds should be required to publicly disclose their large investment positions. The regulatory authorities should increase surveillance of hedge funds to ensure that they should not pose a severe risk to the entire financial system.

Since these funds operate on a global scale, it is pertinent that national regulatory authorities cooperate and coordinate their policy measures. In fact, the upcoming G-8 Summit in UK offers an opportunity to coordinate international efforts to regulate hedge fund industry. By concentrating on hedge funds, the debate on rebuilding international financial architecture could be brought back to the agenda of global policy-making processes.