The EU's Next Target: Hedge Funds

With European unemployment still rising and consumer confidence at an all-time low, most people don't have much sympathy for the financial sector's Masters of the Universe. And they hold in particularly low regard the whiz kids of private equity and hedge funds who—unfairly or not—have shouldered much popular blame for the global economic crisis.

That antipathy has reached politicians, who are now crafting new rules dictating how firms such as New York-based BlackRock (BLK) or London-based Permira should operate in Europe. The resulting legislation could have major implications for Western economies, reducing the risk associated with alternate investments but also potentially making the Old World a less inviting place for hedge funds and private equity firms to do business.

The European Commission is finalizing tough regulations that would force private equity and hedge funds, whether based in Europe or targeting European investors, to register with EU authorities. The rules would also clamp down on how much capital such funds can borrow, force them to disclose where they're investing, and make them hold larger cash reserves in case their investments go belly up. Now working its way through the European Parliament, the proposed legislation could become law by early 2011.

Reining In Financial Institutions

Policymakers, of course, hope tighter oversight will stop the credit-fueled extravagances that contributed to the global economic crisis. They've already pushed forward other regulations to rein in more conventional financial institutions such as banks, insurers, and money managers. But critics of the pending EU rules argue their impact could be far more negative: By circumscribing how private equity and hedge funds operate, politicians could cut off a major source of financial innovation that Europe sorely needs to jump-start its economy.

Representatives of the alternative investments industry also gripe that the crackdown is politically motivated—driven more by anger and resentment in Continental European capitals over the abuses of "Anglo-Saxon" capitalism than by the reality of the small role such firms actually played in the current downturn.

"What Europe needs is a greater ability to restructure and reinvent itself," says Alastair Milne, a banking and finance expert at City University's Cass Business School in London. "Many parts of Europe, even places like Germany, could benefit from what private equity has to offer."

That's not to say alternative investments were completely blameless in the meltdown. Tighter rules, especially concerning how leveraged firms could become, might have stopped some of the abuses that prevailed two years ago. Increased transparency might also have helped investors make more informed decisions about where to park their money.

Industry experts concede that some changes will be salutary but argue that Brussels' reform attempts could do more harm than good. Under the proposals, managers with funds of more than €100 million ($140 million)—accounting for roughly 90% of assets under management in Europe—must register with regulators, who will scrutinize how companies fund acquisitions.

That and other restrictions could force some financial players to rethink investing in Europe, says Andrew Baker, chief executive of the Alternative Investment Management Assn. (AIMA), a trade body. That's because the regulatory burden will increase the cost of doing business and make Europe relatively less competitive vs. regions such as Asia that aren't following the Old World's lead. "Funds will look at other parts of the world for opportunities," Baker says.

Hard on London?

If financial institutions in Europe start heading for the door, it will be London—the Continent's financial capital—that will be worst hit. Currently, more than four-fifths of European alternative investment players are based in the British capital, which fears billions of dollars of capital could be lost if Brussels' reforms are approved.

In response, the British government has proposed its own somewhat watered-down plan to manage the country's largest hedge funds and private equity firms through a beefed-up Financial Services Authority, the country's financial watchdog. But few expect these plans to gain traction compared with those already outlined by the European Commission. "Attention [over policy] has shifted to Brussels," says Rym Ayadi, senior research fellow at the Centre for European Policy Studies, a Brussels-based think tank.

Some also doubt whether the new rules are still needed, given the industry's sharp downturn. The economic slump and a contraction in bank lending already have reduced the number of leveraged buyouts—a major activity of private equity firms—by 60% in the first half of 2009, compared with the same period last year, according to data provider Dealogic (DL.L). The value of deals has similarly fallen 90%, to $6.8 billion, over the same period. With economic conditions continuing to squeeze the industry, some say adding yet more regulation might only make matters worse. "The market will be much more effective at sorting things out than policymakers in Brussels," sniffs a London-based financial lawyer who works for private equity firms but declines to be named.

"Much at Stake"

The bigger danger is that despite the shortcomings of private equity and hedge funds, driving them away could harm Europe's long-term growth. Their business models rely on identifying underperforming businesses (and other assets) and wringing value out of them—an essential tool for improving efficiency and creating wealth.

Going after the Masters of the Universe may help EU politicians win votes, but overzealous reform could put Europe at a global disadvantage if money moves instead to more hospitable locales. Says the AIMA's Baker: "Brussels shouldn't muck around with international capital flows. There's too much at stake."

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