Financial Services is the only commodity in history that has commanded a 30% margin for much of its existence. This is a direct consequence of it curious composition. Traditionally, financial firms have had two streams of income: fee based and fund based. As an intermediary, this is an important distinction to make as to whether it has its capital on the line or not. In the bull markets since the 1980s, banks have done extremely well in deploying their capital, to the extent that a lot of the large banks have come to be known as hedge funds masquerading as investment banks. McKinsey in a recent study counts Private Equity, especially Hedge Funds as one of the emerging power brokers for this century. It is interesting to explore the emergence of Hedge funds in the last couple of decades, as a change in incentive structures within banks.
Employees are the largest cost base for banks and credited with being the critical differentiators. A bank can spend anywhere between 35 to 55% of its revenues on employee costs. As a vestige from the partnership days, bankers still tend to think of themselves as the real owners even after going public! Private equity tries to directly address this issue by refocusing on fund based businesses exclusively, moving to performance pay – the infamous 2&20 Model and not so surprisingly back to the partnership form. We can view this charitably, as further re-intermediation where Private Equity deploys funds and banks are left to tend to transactional work. Or we can look at this as a trend mistaking the underlying bull market for competence and therefore, finds it difficult to sustain as an evolutionary model. Not surprisingly, the rise of Hedge Funds has coincided with historically low interest rates and one of the biggest secular bull runs in history.
Investors capturing a greater portion of the value they have helped create are wonderfully capitalistic, but what matters are the inherent incentives of the 2&20 Model. There is the first criticism that PEs simply try to create a large enough fund that would give great base pay irrespective of performance. In this, it acts similarly to mutual funds, a great majority of whom underperform the markets. There is a need to tie the 2% to the size of the fund and the need to have the managers co-invest a meaningful amount in the fund. Hedge funds also have two lethal advantages over the mutual funds structure: they are allowed to trade in derivatives and are not bound by stringent disclosure norms. What is alarming is the incentive to aim for the fences where they get to retain 20% of the spoils while not bearing any of the loss. This is leading to an extreme case of moral hazard. So, when Greenspan admits that he and others underestimated the self-interest of bankers to prevent them from doing anything stupid - he is thinking of the old I-Bank incentive structure.
The incentive problem has been exacerbated by no-interest rate loans in low-growth economies. Hedge funds thrive in conditions of excess liquidity. And in that, we can be assured that the era of hedge funds is far from over! This nervous capital will move from asset class to asset class creating asset price bubbles in its wake. Low cost of capital is lulling us into lowering our risk premium perhaps as a direct consequence of a belief in the great moderation. This bidding up of prices is encouraging quick movement of capital (liquidity provision function) which is bringing volatility in its wake. All this is going to bring the focus back squarely on the making–trading continuum and how each is incentivized. OECD monetary policy will also have to change its focus to managing asset price build ups.
Add to this the awesome leverage of derivatives and the simultaneously alarming ignorance around its fundamentals, and you have a heady mix of ingredients for crisis. While derivatives have been around from over two centuries as hedging instruments (where Hedge Funds get their name!), its use in making directional bets has created severe disruptions. From being agents of risk transfer through use of derivatives, hedge funds have become liquidity providers as the majority of what they do is to find a gap in the markets and bridge it through statistical arbitrage. The large returns they enjoy are thanks, in large part, to the gearing they employ – sometimes as high as 1:50.
As liquidity providers, banks make 3%; with on-demand, unsecured funds hedge funds can certainly double that spread, but 7 times that?! When money is available for free, how can deploying that capital capture the most value? More likely, the market is over pricing the value Private Equity creates because it is looking only at half a cycle return, where rising markets have created huge demand for alternate assets without factoring in a full-cycle return? There is strong evidence to this as apart from a few funds, most of these funds underperform.
For businesses expressly seeking idiosyncratic risk, there has to be a system for stringent capital adequacy and risk transfer provisions and the means to tie debt assumption to these. While capital adequacy can be tied to risk management methods like VaR, funds have to get prescribed insurance to account for gaps in the model.
So, where do we look for answers when the best seem to be floundering with half baked ideas? The solution, perhaps, lies in the parting words of Greenspan – yeah, the same guy who started all this! He talks at length about letting the Equity Risk Premium find its level. Whenever this premium has shrunk, it has led to a boom-bust scenario. Let us look at this thought in the context of what really happened. Banks have traditionally lent at the most attractive rates to its largest clients in the belief that they are the most suited to return the principal and allow the banks their spread; in other words they are low risk. These large companies have in turn invested their relative lower cost capital in projects with higher risk for that additional return. This takes on a feverish pitch with banks falling over each other to lend bigger and bigger amounts at lower and lower prices to hedge funds and private equity companies, till something gives. At the peak of the PE boom, large firms were able to finance deals at 7.5-8X leverage; hedge funds routinely employ leverage of 20X or over. When asset prices correct, the underlying asset can no longer underwrite the losses and the company’s equity was never enough or for that matter, considered in the first place. The underlying thought is that while equity may not be sufficient to justify the transaction, the entity is so large that it cannot be allowed to fall. Bailing out companies working clearly outside the risk-return continuum only reinforces this thinking. It is like acceding to the demand of a hijacker; if you give in once, you will spawn me-toos.
Since interventionist policy has had a terrible track-record of managing the economy, we have to ensure that the cost of capital prices risk adequately. To achieve this, we need to relook at how we categorize debt. For certain high-risk, non-operating transactions for which unsecured loans are extended, debt has to be treated as equity. That means removing its seniority to equity in the capital structure and perhaps even tax deductibility. This will increase the cost of capital inline with its risk for both the lender and the borrower, bringing back the focus on asset quality rather than the size of the entity availing the loan. The disclosures also have to include all off-balance sheet financing so that both debt and equity providers know the risk they are undertaking. This anomaly, if anything, should be the focus of policy at this stage, as the markets have not been able to or allowed to correct this for some time now. Equity risk premium has been much better at pricing the risk because there has never been a great rush to bail out the individual investor when he makes a wrong investment.