The political push against private equity

Private equity has taken a bit of a back seat recently to the subprime mess, but an article in the Financial Times today (see "Capital markets face shift to opaque investors") shows that the issue is hardly forgotten. As the hidden assumptions and unquoted opinions in the FT piece show, much of the concern about private equity is not coming from the United States (this time), but from Europe. And, surprisingly, some of the most concerned are not the locust-basing Germans, but the British.

In the US, of course, private equity is also an issue -- albeit for different reasons. US Senators Byron Dorgan (D - North Dakota) and Tim Johnson (D - South Dakota) have asked the General Accounting Office to study the issue of private equity, particularly as it relates to the safety and soundness of the US financial system. European regulators have similar concerns, but, in addition, they have other more "societal" issues. These include concerns that private equity investors do not provide sufficient information to corporate "stakeholders" -- particularly labor unions and government regulators. Citing a new study by a management consulting firm, Joanna Chung's article in the FT highlights these issues by focusing on how "regulators" now have less information about their markets because private equity firms are "opaque":

Global financial markets face a permanent shift in power from traditional money managers to opaque groups such as petro-dollar investors, Asian central banks, hedge funds and private equity groups, according to a study out Thursday.

These power brokers had amassed $8,400bn in assets by the end of 2006, three times what they held in 2000 when they were “little more than fringe players” in the capital markets... . Their holdings now represent 5 per cent of the world’s $167,000bn of financial assets. If current trends continue, they could control assets worth $20,700bn, or nearly three-quarters of the size of global pension funds, by 2012.

However, the study says the four investor groups often lack transparency and are out of the reach of regulators.

“It is true that there is not the kind of light shed on some of these activities in the way we are used to,” said Diana Farrell, director of MGI and one of the authors of the report. “The Anglo-Saxon model of capitalism will be challenged. We need to evolve in terms of regulatory oversight.”

Not stated in the article, however, is the considerable (though subtle) divide that exists between the United States and Europe on the issue of "investor transparency." In the United States, "transparency" is a matter for issuers and financial firms -- a tool to protect investors. Investor disclosure generally only comes into play where a takeover is involved or where an "insider" is purchasing or selling securities. Neither of these issues depend on whether the investor is a regulated investment bank or a private equity firm. In short, US market regulation largely doesn't care about "investor transparency".

In the UK, on the other hand, things are quite different. The United Kingdom's "light touch" oversight, in many ways, works at all because there is an underlying monopsony of large investment firms. These firms, with deep roots in the City of London, act as the primary UK market police. They mandate corporate codes of conduct, punish boards of directors by having the (rarely used) power to vote off recalcitrant board members, and, generally speaking, act like a good old fashioned guild.

Add private equity firms into this City mix, and suddenly the guild system is in danger. Private equity firms are numerous, have different values, with members who didn't all go to the same schools. A lot are not British at all. Suddenly, a market that prides itself on its "light touch" oversight is calling for greater regulation of these outsiders. We shouldn't be surprised.

All of this serves as an interesting case study in how politics and regulation intersect. Over the past year or so, there has been a lot of discussion about the philosophical differences between regulation in the United States and the UK, with the UK often portrayed as more flexible and far less heavy-handed. But the reality is that regulation in the United States and the United Kingdom (and pretty much everywhere else) is designed to benefit a domestic constituency. In the United States, for historical reasons, there are two (often conflicting) constituencies -- issuers and retail investors. Hence, strong shareholder litigation rights, a strong SEC enforcement regime, and almost no other shareholder rights or constraints on management. Contrary to popular opinion, New York's financial industry is not a major political constituency.

In the UK, by contrast, the City's financial industry is a major political power, while retail investors and issuers (comparatively speaking) are not. This latter point may seem odd when you consider that the London Stock Exchange and the UK Financial Services Authority advertises the UK as a "Sarbanes-Oxley-free zone". But, while UK-based issuers do not have to deal with SOX, they do have to deal with a host of other, frankly more nettlesome, regulations regarding labor, advertising, environmental and consumer protection, etc. At the same time, the LSE's SOX-free zone isn't designed to benefit issuers -- at least primarily. By offering London as a low-oversight market, the City attracts foreign issuers, which means money for London's financial firms. Since sophisticated investors in the UK (or in the US, for that matter) do not rely primarily on the regulator for protection from dishonest issuers, potentially greater fraud in the UK retail market is but a small price to pay for the extra fees these firms can draw by attracting foreign issuers.

In other words, there is no "Anglo-Saxon" model of capitalism to be challenged, at least in the financial realm.

All of that said, Chung's article does touch on a separate issue of concern in the United States -- sovereign wealth funds. These foreign government-owned funds do present transparency (and trade, and strategic) issues for the US government. But these concerns are quite different from the purportively non-transparent investor concerns otherwise highlighted in the article.