Fair and free markets do not just happen — they require good governance. Over the last two decades, private markets, which include private equity, hedge funds, venture capital and other types of investments, have exploded, now accounting for $18tn in gross assets. Private equity alone represents 9 per cent of all US pension assets. And yet regulation has remained almost non-existent relative to public markets or the formal banking sector.
That may be about to change. Gary Gensler, the chair of the US Securities and Exchange Commission, announced new rules on Wednesday to shine a much needed light on to an increasingly important but opaque area of financial markets. The SEC proposals would require audits of private funds, bans on excess fees and prohibitions on preferential terms for certain investors in private markets, among other things. The upshot would be to put private funds and those that invest in them on an equal playing field, one in which giant firms and hedge funds no longer hold all the cards.
That is crucial given that so much of average individuals’ retirement money is now held in private markets. While giant pension funds might seem like savvy market participants, a lack of transparency in private funds means that even big investors have a hard time getting access to real return data, or understanding who the limited partners are in the funds in which they are investing. Financial reform advocates complain that a lack of standardisation in fees and accounting also enables private equity to disguise how funds perform relative to peers or the wider market. Private fund advisers can cut better deals with some pension funds and investors than others. That means that the transparency and equal access to information on both sides of a transaction which is required for a well-functioning market does not exist.
Once it comes, investors may fall out of love with some of those private funds. Recently, there has been a raft of academic research showing that many private equity and hedge funds are simply not a great investment. One 2015 study by the University of Virginia found that post-2005 vintage private equity firms’ performance did not exceed that of the S&P 500 index, and that newer funds could not even match the index. That relative performance pattern may be disrupted as public equity markets falter. But it still raises questions for pension schemes that have poured into such private funds hoping they can help bridge the gap between the returns promised to pensioners and those achievable through their investments.
While hedge fund and private equity managers are likely to push back hard against the new rules, the SEC is right to propose them. The regulator was, after all, set up in the 1930s, when markets were just as fragile and opaque as they are now. Back then, Congress addressed this by introducing federal securities laws that increased transparency, setting up public listing and reporting requirements for companies on national exchanges. It expanded those rules in the 1960s to include areas such as over-the-counter markets, which had grown big and dark.
It is time for another such expansion of financial regulation. The scale and obscurity of private markets, and the rate at which they have been snapping up new targets, gives the sector systemic importance on a par with the highly regulated banking industry, both in the US and in the UK and EU. The SEC’s proposals are needed not only to make markets function better in the technical sense, but also to increase the public’s faith in market capitalism.