This past week, even jaded observers of Wall Street were startled to learn that last year's top hedge fund manager, James Simons of Renaissance Technologies, made $1.7 billion in 2006. Alpha Magazine reported that the top 25 hedge fund earners garnered an average of $570 million in 2006, up from $362 million in 2005.
The burgeoning hedge fund and private equity industries are both a cause and a symptom of a dangerously lopsided America. Because they are private (not listed on stock exchanges or offering shares to the public), these funds do not have to disclose their inner workings to regulators or to the public. Yet these unregulated funds are increasingly buying and selling some of our largest corporations, stripping assets, piling on debt, leaving employees and subsequent buyers to dig out of a deep hole.
The difference between hedge funds (unregulated mutual funds for very wealthy individuals) and private equity (privately held firms that buy and sell entire companies) is collapsing, creating an unregulated sector of wild-west financial engineering rife with conflicts of interest.
Defenders of private equity operators argue that by ruthlessly squeezing out costs, these traders add to the efficiency of the economy. Earlier in their history, some private equity companies like KKR did specialize in purchasing underperforming companies, improving their management, eventually re-selling them in public stock offerings, and reaped just rewards.
Those days are mostly gone. Increasingly, private equity has little in common with old-fashioned super-investors such as Warren Buffett, who makes large returns for himself and his shareholders by buying, holding, and improving the performance of companies. Today, the idea is to borrow huge sums, purchase a company largely with other people's money, pay yourself huge dividends, strip and sell profitable assets, cut labor and pension costs, and then unload the remains onto someone else.
But as private equity becomes an ever bigger player, its operators are running into the law of large numbers. Everybody can't beat the market. The Financial Times recently reported that in 2006, the average hedge fund, despite huge fees paid to its managers, actually underperformed the S&P 500.
As hedge fund and private-equity operators try ever harder in the face of more competition to produce exorbitant returns, they do ever-riskier and more conflict-laden deals. This trend increases the damage to the economy, the extremes of inequality, and the risks to the system.
When Long Term Capital Management -- a hedge fund specializing in currency speculation -- went broke in the late 1990s, it had borrowed so much money from so many Wall Street banks that the Federal Reserve had to organize a rescue lest the fund take down several banks with it. It would be much harder for the Fed to mount a similar rescue today. And with thousands of hedge funds managing an estimated $1.7 trillion , many making highly speculative bets with borrowed money, a shift to higher interest rates could trigger an old fashioned financial panic.
Beyond the risk of a crash, hedge funds and private equity operators are driving the wrong brand of capitalism. Theirs is a capitalism of windfall returns for financial engineers, and less security and income for workaday Americans. Hedge fund capitalism also signals that real entrepreneurship -- patiently nurturing a new idea and building a company of managers and employees -- is for suckers.
Private equity and hedge fund operators should be subject to the same disclosure and conflict-of-interest requirements as corporations that list their stocks. Congress should repeal the tax-deductibility of the interest on leveraged buy-outs, so that buyers need to invest their own money.
These reforms are not on the agenda in the United States. However, there is increasing push-back from Europe. As private equity takeovers have begun looting well-managed European companies, political leaders across the spectrum are warning that Europe's entire social model is suddenly at risk -- a model built on industrial partnership, good wages, and long-term investment in employees.
European central bankers and center-right as well as leftist politicians have been calling for tighter regulation. In France, presidential front-runner Nicolas Sarkozy recently attacked funds that "buy up a company, sell it off in pieces, sack 25 percent of the staff in the meantime, collect 25 percent profit, and create zero wealth." And he's the conservative in the race.
Sadly, it will probably take another financial meltdown of at least the scale of the 2000-01 crash before reforms are taken seriously in the United States. Hedge funds also invest in politics, and too many Democrats as well as Republicans raise too much money from Wall Street.
A version of this column originally appeared in the Boston Globe.
