In March the UK government released its analysis of and response to the banking crisis, a 122-report from Lord Adair Turner, chairman of the Financial Services Authority. Although leveraged buyouts were referenced once as a factor underlying rapid credit expansion in the US leading up to the crisis, the words “private equity” did not appear in the report once, undoubtedly leading many a general partner to heave a sigh of relief.
Hedge funds do appear in the report throughout, and regulators around the world have a tendency to lump hedge funds and private equity funds together. But Turner's prescriptions for the industry are mild. Having determined that hedge fund activities are not bank-like in nature and pose little systemic risk, the review recommends no immediate increased regulation. Turner merely suggests the following:
“Authorities should have the power to gather information on all significant unregulated financial institutions (e.g. hedge funds) to allow assessment of overall system-wide risks. Regulators should have the power to extend prudential regulation of capital and liquidity or impose other restrictions if any institution or group of institutions develops bank-like features that threaten financial stability and/or otherwise become systemically significant.”
Until such a time as private equity is deemed systemically significant, it will mainly feel the impact of the Turner Review through the increased restrictions it seeks to impose on bank lending, and the resulting decrease in available credit. The review calls for stricter capital requirements for bank lending across the board: banks should have to hold more and better capital against their loan portfolios. Furthermore, Turner seeks to limit to procyclicality of current lending rules by raising capital requirements during economic upswings, and lowering them during recessions.
The review also makes some recommendations in a section on risk management and governance that may affect private equity managers: the skill level and time commitment required for non-executive directors at large banks should be increased, and measures should be put into place to ensure the independence and technical competence of risk management functions. Furthermore, risk management considerations should be embedded in remuneration policy. Again, though for the moment banks are the explicit targets of these recommendations, the review indicates that all regulated firms should be subject to stricter standards in these areas.
Those private equity funds domiciled offshore should note that the review says the FSA is particularly interested in making sure that offshore financial centres comply with global agreements on regulatory standards.
Hedge fund musings
“The FSA already regulates UK-domiciled hedge fund asset managers more extensively than several other regulatory authorities. These fund managers are FSA-authorised and their business is subject to regulation and supervision consistent with FSA Rules and European Directives, covering the capital required to run an asset manager business and conduct of business. But the hedge funds themselves (which are usually legally domiciled offshore) are not currently subject to prudential regulations affecting their capital adequacy or liquidity. This reflects the fact that hedge funds in general are not today bank-like in their activities. Hedge fund leverage is typically well below that of banks – about two to three on average. They do not in general deal directly with retail customers (though they may have indirect contact via funds of funds). And they typically have not promised to their investors that funds are available on demand, and are able to apply redemption gates in the event of significant investor withdrawals. They are not therefore at present performing a maturity transformation function fully equivalent to that performed by banks, investment banks, SIVs and mutual funds in the run-up to the crisis.
But hedge fund activity in aggregate can have an important procyclical systemic impact. The simultaneous attempt by many hedge funds to deleverage and meet investor redemptions may well have played an important role over the last six months in depressing securities prices in a self-fulfilling cycle. And it is possible that hedge funds could evolve in future years in their scale, their leverage and their customer promises, in a way which made them more bank-like and more systemically important… We need a regulatory philosophy which in future will spot such an evolution and respond in time.”