Felix Salmon

How Congress works for you, private-equity edition

By Felix Salmon
May 8, 2011

I had a long discussion at lunch today talking about my theory that it’s just as well the Basel III process was ill-publicized and depoliticized. Because when issues get onto Congress’s radar, the quality of debate can be low indeed. Take this debate between two Democrats on the question of whether private-equity funds should register themselves with the SEC:

Rep. Jim Himes, D-Conn., said that private equity funds act a lot like venture capital funds, which are exempt from SEC registration under Dodd-Frank.

“Private equity entities do not employ leverage any more than venture capitalists do,” he said.

Mr. Himes praised private equity funds for staying in falling markets when others are fleeing.

“They are countercyclical investors,” he said.

Despite Mr. Himes’ support, the ranking Democrat on the subcommittee opposes Mr. Hurt’s bill. Rep. Maxine Waters, D-Calif., said that putting private equity under the SEC’s aegis would better protect public pensions in part because it would subject private equity advisers to a fiduciary duty.

Even by Congressional standards, “private equity entities do not employ leverage any more than venture capitalists do” is pretty spectacularly wrong. “Private equity” is, after all, the polite way of saying “leveraged buy-out”, while venture capitalists don’t use debt at all.

As for the idea that PE shops are “countercyclical investors,” wouldn’t that mean that they did more deals when markets plunged during the crisis? As opposed to, say, this?


On the other hand, it’s a rare argument where you end up siding with Maxine Waters, and I’m underwhelmed with her idea that the purpose of the bill is to protect GPs by ensuring that LPs have a fiduciary responsibility.

The main reason for PE shops to be regulated, of course, has very little to do with fiduciary responsibility, and everything to do with the fact that leverage is a systemically-dangerous thing, and regulators need to know where it is and how it’s being put to use. But it can be hard to explain systemic tail risk to the kind of people who only really understand the meaning of a pie chart when they bake an actual pie.

And remember — this is the Democrats, who tend to be slightly — slightly — more sophisticated about such matters than the Republicans. People like Brad Miller and Barney Frank really do know what they’re talking about. But it’s hard for them to compete with armies of lobbyists intent on dumbing everything down to the point of utter nonsense.

7 comments so far | RSS Comments RSS

There are two kinds of PE deals – the ones where distressed companies are bought for pennies on the dollar, without leverage, and then there are the parasitic debt-laden acquisitions of usually profitable companies that often end up in bankruptcy. The former does not need regulation, as those deals demand competence in the PE funds. It is the latter group of PE deals (I am saying deals instead of firms because a lot of PE firms get involved in both kinds of deals) that require some form of oversight. However, regulation of the PE firms would not be the most efficient nor effective method of preventing disasters.

First of all, how do you come up with a law that says you can’t loan money to people who want to buy a company? And should we protect everybody who wants to loan money to the leveraged buyout parasites? No, if somebody wants to finance, say, the ridiculously over-leveraged purchase of the Tribune Company, even though there is no way their profits can service the debt, go ahead and let them. UNLESS that lender is a bank that is guaranteed by the FDIC, or borrows money from the Federal Reserve. Those two entities must take an active role in monitoring how their clients (i.e, firms that use the FDIC or Fed to raise money they can lend out) use their money. Should an FDIC-insured bank be allowed to finance 90% of an acquisition of a company that must increase profits to be able to afford to service their leveraged buyout? Should the Fed loan them money every night? (No and no).

We don’t need new regulations to minimize systemic risk, we just need the institutions that are supposed to guarantee the fidelity of our financial system to do their job. You don’t just back up or lend money to people without asking what they are going to do with it, and this doesn’t require new laws or policies or governing bodies.

We shouldn’t be creating an agency to regulate PE firms to protect pension funds; if the pension funds are not capable of picking the right investments, then maybe we need an agency to regulate the pension funds.

Posted by KenG_CA | Report as abusive

As for the quote “private equity entities do not employ leverage any more than venture capitalists do,” I don’t know that it wrong, per se, so much as it is spectacularly misleading. The fund is not the leveraged entity; that is the buyout target. This gives the fund a legal shield against having to pay back all that debt if and when the deal goes sour, and allows lobbyists to say things like “PE funds are not highly levered.” In fact, it is extremely possible for a company to go bankrupt but for the PE shop to make very attractive returns.

Posted by MitchW | Report as abusive

Two mistakes: (1) PE fund managers already have fiduciary duties toward their investors. (2) You got the flow of the duty wrong. It’s from GP (the manager) to LP (the investor).

Posted by jpe12 | Report as abusive

@Felix Salmon: “just as well the Basel III process was ill-publicized and depoliticized”

What do you mean? Basel II regulations failed completely and now, without being held accountable and without correcting their fundamental mistakes, they just go on digging us even deeper into a complex black hole of regulations that not even they understand.

What mistakes?

First, because there has never ever been a financial crisis that has resulted from excessive lending or investments in what was perceived as risky, they have ALL resulted either from fraudulent behavior or excessive lending investments in what was perceived as not risky… and so the capital requirements ordained for the banks by the Basel Committee and that are set higher when the official risk perceived by the official risk perceivers, the credit rating agencies, is high, and lower when the risk is perceived to be lower, are simply put, nonsensical.

Second, because there is absolutely nothing that says that the banks are there to be useless mattresses where to stash away some cash, but there to perform the important societal function of channeling bank credit to those who do not have access to capital markets. There is in the whole package of Basel bank regulations not a single word about the purpose of our banks and only a regulatory Taliban could come up with trying to regulate something for which he has not defined a purpose.

Third, because the Basel Committee relinquished their role as regulators and arrogantly took upon themselves to be the risk-managers of the world, by means of setting their arbitrary risk-weights, and as a direct consequence the banks went and drowned themselves in sovereigns and triple-As.

The Basel Committee should not be defended, it should be held accountable for what it did.

Per Kurowski
A former Executive Director at the World Bank (2002-2004)

Posted by PerKurowski | Report as abusive

To be fair, VC firms do also use leverage; at the company rather than the fund level as MitchW pointed out.

However, unlike traditional PE deals the Venture Debt deals are often only able get loans against real collateral (hardware and other equipment) or intangible but still real intellectual property.

While PE firms however can and currently getting leverage in exchange for the promise of 6-8x cash flow; oh and often without covenants lest they relinquish control of the company to the lenders if the going gets rough.

Posted by mindwalk | Report as abusive

While I won’t argue with the importance of reigning in the rampant use of leverage, I believe oversight ought to start with the allocators of said leverage – particularly those benefitting from the support of the federal government.

Secondly, LBO activity isn’t an accurate or fair measure of private equity activity through cycles. Many of those firms focused on buyouts during the bull market have shifted gears by allocating significant capital to distressed debt strategies.

Posted by troutmann | Report as abusive

I believe you are misinterpreting Rep. Himes’ comments. When Rep. Himes indicates that PE firms do not employ leverage, he means that, like VC funds, PE funds themselves are not leveraged. The underlying portfolio companies may have debt in their capital structures (similar to a large proportion of non-PE owned companies). The distinction is highly relevant in the regulatory context if the presupposition is that leverage creates systemic risk. Since neither fund structure employs leverage within the fund, there is no more systemic risk to failure of the underlying investments in a PE fund vs. a VC fund. Many start ups fail, costing their investors some or all of their investments. Portfolio companies in either case can and will go bankrupt. The issue is the impact of that failure on the system. In either case, since an equity investment would be lost, there is no leverage creating systemic risk.

With regard to Rep. Waters’ comments, SEC regulation has no impact on fiduciary duty. GPs in PE funds are currently fiduciaries to their investors and no SEC regulation would alter that duty.

Posted by salmoncommenter | Report as abusive

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