Former Federal Reserve chairman Paul Volcker might want to bone up on the differences between private equity and hedge funds after a Congressional hearing Tuesday.
At the hearing before the Senate Committee on Banking, Housing and Urban Affairs, Volcker testified on proposed regulation bearing his name that would ban commercial banks from investing in private equity or hedge funds, as well as from engaging in proprietary trading.
At one point, he made a general comment to the effect that private equity is just as risky an activity for banks to engage in as hedge fund investing or proprietary banking activity. The three are “substitutable,” he said.
A large part of Volcker’s argument is that all three activities pose clear conflicts of interest for banks, and that is surely a good and crucial point at the heart of his proposals. But saying that PE investing is as risky as hedge fund investing ignores several key differences between the two asset classes.
Traditional private equity funds are fundamentally different creatures than the majority of hedge funds for a lot of reasons: because they invest in companies, not intangible financial assets; because their capital tends to be locked up for far longer; and because few of them are leveraged at the fund level. These characteristics make it less likely that a PE fund will cause financial contagion, since its assets have a concrete value, since clients can’t just start pulling their capital if a panic sets in, and since the hazards of a leveraged bet gone bad are smaller.
Volcker gave us additional ground to question his understanding of this point late in the hearing, when Sen. Charles Schumer (D-N.Y.) asked him about interconnectedness and the risks of contagion. Volcker said in response that contagion is less likely at private equity firms AND at hedge funds [emphasis added] than at banks because both types of institutions “typically don’t take short-term money.” Sure, hedge funds don’t rely on funding that can be pulled overnight, but we still feel like this is a massive glossing over of the fundamentals.
Consider the differences in the historical record. The example of Long-Term Capital Management clearly showed that hedge funds can on occasion pose systemic risk. Arguably, two Bear Stearns Cos.’ hedge funds stood at the beginning of the end for that institution.
Contrast that with private equity. While you’ll occasionally find a private equity firm whose name is associated with a hedge fund-like vehicle that ran into trouble – think Carlyle Capital Corp. - we can’t think of a single instance in which a traditional PE fund – one that invests in companies and has a 10-year lock-up – has led to financial contagion.
To be sure, the private equity industry bears some of the blame for the confusion, given that it willingly engaged in more hedge fund-like activities during the boom, when “convergence” was a buzz word and mortgage investing was all the rage. But the PE industry has been making the point for months now that its core business is massively different than the core business of hedge funds. The topic deserves a more nuanced approach from our nation’s lawmakers.
For the Wall Street Journal’s full coverage of today’s hearing, go here.