Private equity, hedge funds, and the ‘pointy end’ of capitalism

It is increasingly difficult to find someone who is agnostic about private equity and hedge funds.

Many in the financial industry champion these investment vehicles as a means to deliver absolute returns, regardless of which way the market is moving on any given day, while providing other market participants with much need liquidity.

Critics, however, have become louder and louder in recent years. A number of hedge fund blow-ups have raised concerns over the consequences for the “real economy”. Names of now-defunct firms such as Long-Term Capital Management and Amaranth Advisors have become bywords for the possible systemic risks that we could face if a hedge fund is big enough and its bets are wrong enough. With the US presidential campaign of Mitt Romney in 2012, private equity has been examined under the microscope like never before.

Private equity and hedge funds operate within the financial markets alongside the large institutions that populate Wall Street and the City of London. However, their entrepreneurial nature distinguishes them in a number of very important respects from investment banks, stockbrokers and other firms that operate as intermediaries.

Private equity and hedge funds are not middlemen. They actually buy and sell financial assets rather than simply facilitating transactions by other market participants. They take risks in a way that traditional intermediates studiously avoid (at least intentionally). As private equity and hedge funds back one company or industry over others, they are open to the possibility of stratospheric profit and catastrophic loss.

Many experts and commentators feel that a healthy, vibrant Wall Street is essential to a robust economy. Few hedge fund managers and private equity firms would disagree.

In April 2012, US President Barack Obama shocked many in and out of the financial services industry by signing into law the acronym-friendly Jump-start Our Business Start-ups Act (or “JOBS Act” for short).

Intended to undo many of the impediments to initial public offerings (IPOs) that were the unforeseen consequences of the passing of the Sarbanes-Oxley Act in 2002, the JOBS Act significantly revamps the way in which private capital is raised in the US. The intended beneficiaries of this liberalisation are so-called “emerging growth companies”, whose IPOs and resulting jobs and economic growth federal lawmakers want to expedite.

However, private investment vehicles, such as hedge funds, private equity funds, venture capital funds and mezzanine funds, also benefit from the JOBS Act. These funds are now able to more easily obtain money from “accredited investors”, which include those individuals who earn more than $200,000 per year or have more than $1,000,000 in net worth, excluding their family home.

Until now, it has been necessary for anyone approaching prospective investors in the US to have a substantial pre-existing relationship in place in order to actually discuss a particular investment opportunity with them or provide them with marketing materials. Post-JOBS Act, anyone can be approached — as long as it is determined before they invest that the individual in question is actually an accredited investor.

What could this mean in practice? Perhaps full page advertisements in daily newspapers, or GQ magazine, or Sports Illustrated? Maybe commercials during the Super Bowl, or during the sombre Sunday morning talk shows, like Face the Nation  or Meet the Press? What about mass mailings to everyone in a particular state who bought a Mercedes-Benz, or a Rolex watch, last year? All of the above are now fair game!

As private equity and hedge funds continue to enter mainstream life around the world, it becomes more and more important for all of us to have a clear understanding of what it is that they really do, who benefits from their successes and who is at risk from their losses. These funds and the firms that manage them are too important to ignore or to explain away with simplistic and shallow rhetoric.

An unorthodox, but potentially rewarding place to look for a fresh perspective on these questions is to ask, what do poets, those unelected legislators of the world, think about private equity and hedge funds?

Fortunately, we do not have to rummage through countless Quartro-size pages of free verse and laboured sonnets to find this answer. Instead, we can look to a scandal that recently enveloped a leading British literary prize, and subsequently reached newspapers and media reports around the world.

In 2011, to great media fanfare, two well-known poets, Alice Oswald and John Kinsella, withdrew their names from consideration for the Poetry Book Society’s prestigious TS Eliot Prize. The reason? The prize that year was sponsored by Aurum Funds, a hedge fund that donated money when the Society lost its public grant due to cuts in the British budget that were a consequence of austerity measures.

As you would expect from a poet, Kinsella was not at a loss for words. When asked why he withdrew his name from consideration, he pithily referred to hedge funds as the “very pointy end of capitalism”.

Obama’s JOBS Act opens the door for more US investors to put their money to work with private equity and hedge funds operating at capitalism’s “very pointy end”. Some of these investors will be rewarded, other may lose significant sums.

There is no need either to demonise or romanticise private equity and hedge funds. Capitalism’s pointy end is where they must operate in order to uncover those lucrative returns for their investors, which include public employee retirement plans, university endowments and charities.

Post-JOBS Act, Obama has placed responsibility for these investment decisions squarely in the hands of men and women with an appetite for risk. As a result, a prospective investor in private equity and hedge funds must dedicate the necessary time and attention before they invest, in order to ensure that they do not end up sticking this “pointy end” into their own eye.

Timothy Spangler is an adjunct professor at University of California, Los Angeles.

This article was first published at The Conversation.