Financial Transparency: Controlling The Private ‘Locusts’

Source : The Straits Times,Apr 8, 2008

THE full repercussions of the financial crisis triggered by bad mortgages in the United States are still unclear. But the unforeseen effects already include a demand for greater transparency in financial markets and better regulation.

One part of the financial markets not subject to the disclosure rules that apply to banks is hedge and private equity funds. Once small, the five biggest private equity deals now involve more money than the annual budgets of Russia and India. Assets in private equity and hedge funds stand at US$3 trillion (S$4.1 trillion) today and are expected to reach US$10 trillion by the end of 2010. The funds rely heavily on investment from pension funds, and on money borrowed from banks and other non-private sources.

Indeed, these private funds account for about two-thirds of all new debt. In short, they are a major challenge to financial stability. Unless regulated, they are likely to contribute to future crises.

The big private equity funds have proven to be a menace to healthy companies and to the European Union’s Lisbon Agenda, which aims to make Europe the world’s most competitive economy. Typically, they take over companies with borrowed money - often more than 80 per cent of the price. These ‘leveraged buy-outs’ leave the company saddled with debt and interest payments. A once profitable and healthy firm is milked for short-term profits, benefiting neither workers nor the real economy.

In Denmark, telecommunications company TDC was taken over by a group of private equity firms in 2005, with 80 per cent of the purchase financed by borrowing. The company’s debt-to-asset ratio leapt from 18 per cent to 90 per cent as company reserves for long-term development - essential in the telecoms industry - were used to service the loan.

These funds are also largely tax-exempt, often because they are registered offshore, although they operate from the world’s major onshore financial centres. One fund manager admitted that he paid less tax than his cleaning lady. In the US, it has been calculated that the funds cost between US$2 billion and US$3 billion in lost tax revenues - an amount three times that of the EU’s budget for humanitarian aid.

Trade unions in Britain, Germany, Canada and elsewhere have long pointed to the damage caused by leveraged buy-outs. So have such senior politicians as former German vice-chancellor Franz M�ntefering, who described private equity funds as ‘locusts’, as well as leading Democrats in the US Congress. The European Parliament’s Socialist Group, Britain’s House of Commons and the Australian Parliament have all investigated these private funds.

At the EU’s autumn summit, British Prime Minister Gordon Brown, German Chancellor Angela Merkel and French President Nicolas Sarkozy agreed in a joint statement that more transparency is needed in financial markets. In a separate move, Mr Brown promised to close any legal loopholes that enable hedge fund managers to exempt themselves from paying taxes.

Both the private equity and hedge fund industries reacted by publishing voluntary codes of conduct. Mr Paul Marshall, a hedge fund chairman, told the Financial Times that he hoped voluntary action by the industry ‘will take the pressure off’. At least that was transparent.

Nobody wants to demonise or unnecessarily restrict private equity and hedge funds. Venture capital’s investment in innovative and high-risk new companies highlights their potentially useful role. But this accounts for only a minor part (5 per cent) of the private equity industry. Given that the largest part of the industry (60 per cent) is based on leveraged buy-outs and extreme debt, it seems only reasonable to demand that they honour the transparency and tax rules accepted by everyone else.

Ultimately, private funds should be regulated globally. We can enact measures in each EU member state, but coordinated action by the EU and the US would be a realistic start. Private funds cannot operate without these two giant markets, and would have to comply with their requirements. The will to act exists in the EU. The White House’s current occupant is a more formidable obstacle to reform, but change is coming.

Even so, ensuring transparency and disclosure cannot fully address heavily debt-laden leveraged buy-outs, which would still be objectionable. There is a need to set a limit on the amount of debt that a company can accumulate, and change acquisition and merger legislation to include leverage. There is also a need to protect pension savings, which are now heavily invested in private equity. In short, we need a proper supervisory system for financial services.

There is still a lot of talking to do. Serious discussions are needed to reach EU-wide and inter-governmental agreements, and to encourage the US to move in the same direction. But, for the sake of our pensions, our savings, our jobs and our welfare states, the sooner change comes, the better.

By Poul Nyrup Rasmussen, president of the Party of European Socialists and a former Danish prime minister.