Regulating Private Equity

Thanks to everyone here at Truth on the Market for inviting me to guest-blog for the next couple of weeks. As I mentioned during my stint on the Conglomerate, one of my primary areas of research is private equity, so as before, I’ll be focusing a fair amount on developments in the exciting world of buyouts and venture capital.

To begin, I’d like to comment on yesterday’s story in the Financial Times regarding the formation of a “trade body� to represent the interests of the world’s largest buyout firms. The initiative appears to be in the early phases of development and is being spearheaded by four of the major players in the industry— Blackstone, Carlyle, KKR, and Texas Pacific Group. As the story notes, the move appears to be in response to growing concern among public policymakers and journalists about the growth of private equity and a sense that increased regulation of the industry may be a distinct possibility.

The notion that private equity should be subjected to greater regulatory oversight is hardly new. In fact, calls for increased regulation of the industry have been circulating for some time now. Recently, however, it seems the voices have gotten a lot louder. Hardly a week goes by without some reference to it (for last week’s reference, see here), and no less a bastion of capitalism than Forbes has contributed to the discussion in a rather scathing article on the subject last month (article here). Why all the fuss? Part of the clamor seems to echo the concerns voiced during the buyout frenzy of the 1980s that LBOs ultimately harm employees and communities through layoffs that often follow an LBO (this seems especially true of the criticisms voiced overseas in Germany and France). Other critics focus on the secretive nature of LBO firms and their proclivity for keeping their operations under the radar. For many, this is especially troubling considering how much money is being poured into private equity. As Forbes noted, “globally, 2,700 funds are raising half a trillion dollars in cash to invest; this will bankroll them for $2.5 trillion in deals, given their penchant for putting $4 (or more) of debt leverage atop every dollar they put up.� Add to this the occasional bad buyout deal (e.g., TH Lee’s Refco debacle) and the conclusion seems obvious: the industry needs more regulation to avert a catastrophic meltdown.

To be sure, there are definitely some market imperfections in the private equity industry that should be addressed (more on these later). What concerns me with the current discourse is that the primary criticisms almost always boil down to the same thing: buyout firms are raising too much money (much of it from pension funds) to exist without meaningful regulation. The mere fact that buyout firms are raising record levels of funds, however, says little about why this might be a regulatory problem. Likewise, it says nothing about what regulatory response might be needed (if any). Is there a market failure that results in “too much� money going into private equity? If so, it seems we would be better off trying to isolate this problem at its source (e.g., perhaps we need to reexamine our prudent investor standard). Likewise, if there are problems with favored LBO techniques (e.g., dividend recapitalizations, etc.), why not address these transaction structures directly (just as Congress did in the 1980s with two-tiered tender offers)?

In short, before we talk about regulating private equity, we need a lot more precision in understanding exactly what (if any) problems are posed by the current private equity market and the best means to address them. Otherwise, I fear ending up with another set of hedge fund investment advisor regulations: regulations that give the appearance of providing oversight of a growing industry, but which are of questionable effectiveness.