Hedge funds and Private Equity - PES

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2. Market transparency – a common interest
We have seen from part I and part II that HF and PE industries are characterised by an extreme
lack of transparency, information asymmetry and lack of disclosure on all essential activities.
In our modern European societies, this is in direct contradiction to the overall, general state of
play of fundamental transparency in the real economy, as a basis for participation and responsibility
of our people. The Nobel prize winner in economics, professor J. Stiglitz has shown how
asymmetric information makes the market economy function ie inefficiently and certainly not optimally.
Negative, systemic implications are created by HFs and PEs moving companies from
transparency and disclosure in stock markets and public companies to opacity and lack of disclosure
in the private part of market economy.
With the strong influence of LBO / PEF on financial markets and the adherent macro / micro
risks, the demand for stricter information and transparency in these sectors is growing. Furthermore
investors in LBO / PEF are no longer only very wealthy investors, but partly private retail
investors (directly) or financial institutions who serve the general public or special public groups
(Pension Funds, other public Funds, Insurance companies etc.).The main risks about which information
and transparency are badly needed are: high or even sometimes extremely high leverage,
market value risks, operational / managerial risk, correlation between several risk factors, or collusion
between participants.
Until now there has been practically no direct regulation of LBOs (apart from exchange regulation
and accounting rules) and very light indirect regulation through the banks / Investment Banks
/ Prime Brokers. This indirect approach seems increasingly insufficient, because Investment
Banks as Prime Brokers are strongly dependent in their business volumes and profits on PEF /
LBO firms. They are also increasingly active in proprietary HF and LBO business.
A necessary condition for EMH (efficient market hypothesis) to hold is that information is fully
and equally disseminated to all market participants. The only way to get it is through full disclosure
of positions and moves of the main market players. There are many circumstances where
strategic agents have incentives to make short-run profit in playing a less than idealistic game.
If their move is hidden, they may drive the market in a destabilising direction.
After the 1987 Stock market crash, several models showed that ignorance of the motivations
that initiated the market decline had led to a huge magnification of the crash. One recommendation
of the Brady inquiry 83 was improving disclosure, apparently to no avail. This question is
more relevant than empirical studies showing that mean-reverting processes on equity, bond and
foreign exchange markets have a longer time span than the horizon of market players like hedge
funds. Therefore the disclosure of proprietary trading of hedge funds would be nothing but
setting the right conditions for market discipline. Those who oppose it have other motivations
than improving market efficiency.
As much as tougher competition between hedge funds crowds out standard market-neutral
strategies increase efficiency and drive prices and HF-yields downwards, shifts to more exotic
styles arise in search for higher excess returns. HFs have become even more opaque while they
have been holding assets with hazardous and infrequent valuation via the use of event-driven
situations, the buying of distressed securities and the investment in private equity. Low-frequency
skewed distributions of returns make the computation of volatility unreliable. Value-at-Risk models
used by banks 84 to internally assess credit risk are not suited for hedge funds. Running stress
tests and disclosing results to market supervisors should be a minimal requirement.
83 After the Stock market crash of October 1987, a US presidential task force on market mechanisms, chaired by Senator Nicholas Brady,
was set up to investigate on what went wrong. It was known as the Brady Commission. Among other disturbing factors, the inquiry revealed
the strength of bandwagon effects triggered by portfolio insurance.
84 These are non-anticipated risk measurement models used by banks as supervisors require them capital adequacy provisions. More precisely,
it is the value of losses that could be over passed only a certain % of time. For instance, the value of losses that could be over passed
only 1% of working days.