The Real Stakes in the Hedge Fund Hearings

Congress is taking a close look at the hedge fund industry and how it's regulated. Here is what's really on the line

On Dec. 5, lawmakers shined their spotlight on the hedge fund industry, conducting hearings on the way regulators handled their investigation of hedge fund giant Pequot Capital.

The Senate Judiciary Committee hearing focused on a narrow enforcement issue. It is trying to determine whether the Securities & Exchange Commission might have been improperly influenced when it allowed Morgan Stanley (MS) Chief Executive John Mack to avoid questioning in an inquiry.

The inquiry is focused on trades that involved Morgan Stanley and Pequot, where Mack previously worked as chairman. The New York Times reported on Dec. 5 that SEC investigators took exception to the probe. SEC enforcement chief Linda Thomsen defended the inquiry during her testimony. But committee Chairman Sen. Arlen Specter (R-Pa.) said, "At best, it looks like extraordinarily lax enforcement by the Securities & Exchange Commission.…At worst, it has the overtone of a possible cover-up."

As the hearings proceed industry observers will be looking for clues into just how much enthusiasm lawmakers have for imposing broader controls on the hedge fund industry. Hedge funds are unregulated investment funds that use debt, options, and other techniques for a variety of purposes, such as boosting returns, limiting risk, and taking positions on both sides of a bet.

Push for Regulation

Some hedge funds have posted excellent returns, attracting more capital and allowing them to pull off larger, higher-profile deals (see, 3/1/06, "KKR Hedges Its Bets"). But that success has drawn some unwelcome attention (see, 11/8/06, "Dealmakers Prepare for New Era on Capitol Hill"). Regulators and the media have focused on the blow-up of a few funds, such as Amaranth Advisors (see, 10/9/06, "Amaranth's Loss, Wall Street's Gain "). Such problems have been relatively few in number, and the damage has largely been contained. Yet they have nonetheless led to calls for more regulation of hedge funds, which have been drawing more money from pension funds and even from some smaller, individual investors.

Earlier this year there was an effort to require hedge funds to register as investment companies, which would force them to disclose a certain amount of information about their strategy. The U.S. Court of Appeals in Washington overturned an SEC rule that would have required hedge fund registration. Some industry executives fear that would depress returns because funds would tip off their moves to rivals.

Other executives, however, say there's little to fear, even if the rule is somehow revived. Some private-equity firms and hedge funds have registered as investment advisers for many years. "Registration is no big deal," says Robert L. Friedman, chief administrative officer and chief legal officer of The Blackstone Group, a leading private-equity firm that also has a hedge fund business.

Controversial Debt

The real issue is whether the government will impose limits on the amount of debt that acquiring companies such as private-equity firms use to finance their transactions. Debt, which is referred to in the industry as leverage, has been on the rise during the last few years, although it's still below the high-water mark established in the late 1980s. Debt as a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA) in private buyouts now averages 7.3, according to Standard & Poor's. That's up from a multiple of 4.6 in 2001.

Multiples have increased for several reasons, according to market observers. Interest rates are still at historically low levels, which makes debt cheaper and allows borrowers to take more credit for the same price. Lenders are competing with one another in an increasingly crowded market. Lenders also have developed new ways of selling their debt in the securities market, which lowers risk, too.

Default levels remain well below the historic average. That's bound to change. As deals have been done with more and more debt, more companies are likely to be unable to pay off their obligations, although the default rate could more than double and still remain below the long-term average of 4.7%, according to S&P (see, 11/10/06, "The Dark Side of the M&A Boom").

Threat to the Market?

If the government were to impose leverage limits, the impact on the markets could be significant, industry observers say. Firms use debt to boost their return on investment. If deals become less profitable as a result of leverage limits, big pension funds may cut back on their allocations to alternative investments. Deals could become less competitive, and deal volume and price could decline as a result, weakening the investment market overall.

The other main issue is whether Congress will roll back some of the financial reporting requirements that the Sarbanes-Oxley Act imposed on public companies in the wake of the Enron and WorldCom scandals. If that doesn't happen, U.S.-based markets such as the New York Stock Exchange will continue to lose out in the global initial-public-offering market. While U.S.-based companies continue to list their shares in the U.S., foreign-based companies that once had a clear preference for listing in the U.S. are now increasingly likely to list their shares in other markets such as London, according to Friedman.

The Judiciary Committee's review of the SEC is limited in scope. But the political mood has changed in the wake of the Nov. 7 general election. If lawmakers start shining a broader light on leverage, the impact on the financial markets could be significant.