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In this crisis, what should central banks be thinking about hedge funds and LBOs?
Hello World! Sorry about the long hiatus once again, but I've been busy. It appears though that the recent downturn has not left me much to talk about really other than a few conferences here and there as well as people inquiring about work. So to go in another direction, I thought I would post something I just wrote up regarding hedge funds and LBOs and how it may concern central banks. Please note, I've posted my linkedin profile badge on the right if you feel like you would like to make contact. Cheers!

Hedge Funds May Be Usurping Central Banks Authority

Generally, Leverage Buy-Outs occur when the LBO or private equity firm borrows “or leverages” funds in order to take a controlling stake in another firm. Usually the target firm has hard physical assets and somewhat steady cash flows, or management of the target firm has orchestrated the takeover. The assets of the targeted firm are used as collateral to secure the debt taken on by the LBO firm. In some cases, firms that are bought out are private corporations, but in other cases, public firms are leveraged, bought out and taken private.

When a leverage buy-out occurs, certain issues may arise depending on the two firms’ situations. Managers orchestrating an LBO, according to Ross, Westerfield, Jaffe and Jordon, will tend to work harder since they now own a substantial portion of the business, thus reducing the agency cost of equity (2009). We already know that LBOs will customarily buyout shareholders at a price above market value, but this still leaves the area of manager’s insider information up for speculation and future research. Indeed, the fact that managers chose to buyout equity using leverage suggests prior knowledge to the fair value of the firm and begs the question whether the price paid to shareholders was at a premium or still undervalued. This also is the classical dilemma of shareholder asymmetric information when shareholders choose to sell their shares.

Historically, private equity firms have existed because limited partner investors have trusted them with their funds to make wise investments buying out firms and making a return on this investment. The objective of the PE firm and its investors is generally very clear. Now, enter the hedge fund. Hedge funds, equally, have investors that seek returns on their investments. However, hedge funds survive on making a wide variety of investments in commodities, stocks, debt and so forth, depending on the strategy of the firm. Here lies an area of ambiguity for investors and on regulation of hedge funds. Portfolios of hedge funds and strategies may change very quickly depending on market conditions, and investors need to be aware of this. Furthermore, hedge funds have been in the limelight as of late in their recent appetite for leveraged takeovers. To give an example, here is an excerpt from Reuters in 2007:
Just two years ago [2005], Henry Kravis, co-founder of buyout firm Kohlberg Kravis Roberts & Co. (KKR), speaking at a conference in Frankfurt, said hedge funds were good stock pickers but should be kept out of investing. "Hedge funds are not set up to build value in companies over the long term," he told an audience of private equity firms and their investors. Fast forward to last January, when KKR was involved in the buyout of for-profit education company Laureate Education Inc. Joining KKR in the investor group was S.A.C. Capital, among the largest hedge funds in the world. (Flaherty)
According to AIMA’s Roadmap to Hedge Funds, the hedge fund industry may have managed $2.5 trillion dollars at its peak in the summer of 2008 (Ineichen). As you can see, hedge funds comprise one of the largest asset classes under management. Interestingly enough this is about the size of the damage in the current US recession, but this is beside the point. Thus, it may appear obvious that central banks of various countries and government regulators are a little concerned when it appears that hedge funds may be stepping outside of their mandate stipulated by their limited partners’ PPMs.

Research has shown that hedge funds are taking on an active role in investing in firms with potential for LBOs (Huang, 2008). Based on a hedge funds initial investment, an LBO offer is more likely to occur than with any other investment institution and also shows signs of a significant increase in premium paid for the firm when a hedge fund is present. Having said this though, when there is an LBO boom, hedge funds that do partake in LBOs experience abnormal returns.

As Farrell and Lund (2007) so eloquently put it, "The rush of cash emanating from these players could be fueling asset-price bubbles. Private equity and hedge funds could create new sources of financial-market instability, including higher credit risk and a greater change of "systemic risk" in which one or more large hedge fund failures start a dangerous ripple effect across global capital markets—as occurred in 1998 with the near collapse of Long-Term Capital Management. Because all these players are lightly regulated, they can move huge amounts of money beyond the scrutiny of financial-market authorities."

For a hedge fund to use its funds to lend on a LBO, in a sense, the hedge fund is extending credit much like a bank would. This is cause for concern, since in some cases, a hedge fund’s investors may have been banks themselves who are regulated under a countries central bank. This also means that the cost of debt must either be evenly and competitively matched with other lending institutions or it might be simply more expensive. Thus, here lies another crux of the issue. Banks’ interest on lending is stipulated by central banks of the particular country. In contrast, hedge funds can stipulate their own lending terms simply depending on their desired return, thus taking the central bank out of the equation. So, we have an institution that is lending massive amounts of currency like a bank, but is not regulated like a bank. In addition, hedge fund investors are taking on added risk of paying for above market value stock for companies and entrusting third-party LBO firms to manage their exits. Finally, the public markets exist to allow firms to raise funds by selling portions of equity. By taking more firms private through debt acquisition, the “ethos” of companies’ capital structure- debt vs. equity, not to mention the public market’s existence, is circumvented. When more and more companies are supported by money that was created outside of the central banks control, this affects the central bank’s ability to control monetary supply.

Notwithstanding the recent credit debacle and the “fall” of the hedge fund industry, it is no wonder that regulators were starting to question the methods of hedge fund techniques and beginning to legislate more surveillance. Throw the recent crisis into the mix, and you have plenty of reason for more legislative rigour.

References: Farrell, Diana and Lund, Susan. “Power Brokers” Newsweek International, October 20th, 2007. McKinsey Global Institute.

Flaherty, Michael. “Hedge fund-LBO alliances deepen” Reuters.com. April 9th, 2007. http://www.reuters.com/article/GlobalHedgeFundandPrivateEquity07/idUSN0245257020070409?pageNumber=2

Huang, Jiekun, “Hedge Fund Activism in Leveraged Buyouts” (December 15, 2008). Available at SSRN: http://ssrn.com/abstract=1086687

Ineichen, Alexander and Silberstein, Kurt. “AIMA’s Roadmap to Hedge Funds”. November 2008 The Alternative Investment Management Association. http://www.aima.org/download.cfm/docid/6133E854-63FF-46FC-95347B445AE4ECFC

Ross, Westerfield, Jaffe, Jordan. Corporate Finance: Core Principles and Applications. 2nd Edition. McGraw Hill International 2009. P. 472.

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