Hedge funds and Private Equity - PES

Expert Group claims – with strikingly few references to empirical evidence – that the LTCM crisis
has “prompted the tightening up of controls as investment banks have significantly improved the
way in which they manage their exposures to hedge funds.” 61
Who is right? In the following we will argue that the crisis of LTCM and other hedge funds has
proved to be only a temporary setback for the long-term growth of the hedge fund industry. In
addition, several of the factors that played a central role in the LTCM crisis remain. Last but not
least, regulators still find themselves in a situation with an enormous lack of transparency and
reliable data on which to base informed decisions about threats. Consequently, it is difficult to
take proportionate regulatory action to prevent or counter such treats. For these reasons, we
side with those who believe that hedge funds have created substantial threats to global financial
stability, threats for which there are currently too few remedies.
We will return to the remedies, i.e. recommendations for voluntary and regulatory action in Part
III. Thus the focus of this chapter – and our fifth and last major concern – is on the threats that
hedge funds pose to financial stability. To structure the analysis, it seems useful to distinguish
between six factors explaining why hedge funds may pose threats to financial stability. These
factors are often related, meaning that a financial crisis may be escalated through mutual links
among several factors. For instance, market risk, liquidity risks and leverage may interact. Ideally,
a risk assessment ought to analyse such potential patterns of interaction. Yet, this is beyond the
scope of this chapter. Here we will have to deal with the factors separately. The factors that we
will deal with are:
1. Risk taking in the context of growing competition and high performance fees
2. Growing assets under management
3. Short selling
4. Increasing correlations
5. Concentration on less liquid markets
6. High leverage and concentration in complex derivative products
Before we turn to our analysis of these factors two points ought to be made. First, it should be
emphasised that some of these factors apply to both hedge funds and private equity funds. Thus,
private equity funds may also pose threats to financial stability. However, we believe that the most
alarming threats stem from the hedge fund industry. Consequently, this industry is the sole focus
of this chapter. Secondly, hedge fund size and strategies vary a lot (see also part I). This in turn
means that the threats hedge funds pose to financial stability vary a lot. It is beyond the scope of
this chapter to make detailed descriptions of these variations and assess their implications on financial
stability. Instead, we are forced to deal with a more generalised model of hedge funds.
5.1 Risk taking in the context of growing competition
and high performance fees
More regulated financial institutions are normally reluctant to be exposed to the kind of risk to
which many hedge funds expose themselves. By contrast, hedge funds have always tended to
be risk takers in a number of markets. This is particularly the case in complex markets, where
risks are difficult to quantify and hedge funds have a competitive edge because of their often
superior models. The credit derivatives market that we turn to further below is just one example
of such a complex market. There are several reasons why hedge funds and their managers are
more prone to take risks. In this section we will address two important ones: the extensive use
of performance fees in the remuneration packages of hedge fund managers and increasing
competition in the hedge fund industry.
61 European Commission (2006): Report of the Alternative Investment Expert Group: Managing, Servicing and Marketing Hedge funds in
Europe, http://ec.europa.eu/internal_market/securities/docs/ucits/reports/hedgefunds_en.pdf, p. 12 (08.11.2006).
Part II – Six concerns about our European social market economy
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