GO
Loading...

Hedge Funds: The Next Too Big To Fail Monsters?

Government Regulation
CNBC.com
Government Regulation

Hedge fund regulation is having a seriously perverse—if entirely predictable—effect. Large hedge funds are growing larger, well-known star managers are accumulating more assets under management, and competition from start-ups is becoming scarcer.

Barrier to entry and costs of regulatory compliance have risen dramatically. A new fund must start its life with at least $100 million of assets under management to be commercially viable, according to Hester Plumridge of Heard On The Street. A few years ago, the price of entry was just $50 million.

Much of this is due to new reporting and regulatory requirements both in the US and Europe. The demise of the fund-of-funds sector—largely a side-effect of the Madoff scandal—has further contributed to the problem.

The results are obvious. There has been what Plumridge calls a “flurry of consolidation” in the hedge fund sector, with some of the biggest players swallowing other funds. And there is the invisible consolidation that occurs when money managers who might otherwise start their own firm seek refuge with bigger players.

None of this is particularly driven by considerations of risk or returns. The biggest hedge fund managers have not been out-performing the smaller managers. Instead, the rules of the game have changed to load the dice in favor of the bigger players.

This will give rise to the risk of the “Too Big To Fail” hedge fund. Just as various regulations set the stage for the rise of the megabanks and colossal investment banks, in the name of overseeing the hedge fund sector we’re creating centers of systemic risk.

It’s tempting to call this an unintended consequence—but can we call a consequence unintended if it was so highly predictable? In May of last year I was warning about this effect:

The irony is that the anti-competitive effect may cause further consolidation in hedge funds, perhaps creating funds that—like our behemoth megabanks—are too big too fail.

Witness the news today that the London-based hedge fund Man PLC is acquiring GLG Partners to create a $63 billion hedge fund. This consolidation is occurring just in advance of likely European Union regulations that will require hedge funds to be licensed by national authorities, and subject the licensed funds to risk-management and trading oversight. Greater regulatory oversight seems to be pushing even the biggest funds to get bigger.

I don’t think it’s too cynical to say that this is the intended consequence of the regulation. Established hedge fund managers might not have much clout in Washington, DC—especially compared to the banks—but they have far more clout than small hedge funds just getting their start. The fact that regulation works to the advantage of the big players is not some accidental effect.

Regulators also tend to prefer to deal with a smaller number of large institutions than vast numbers of small funds. It just feels less chaotic, less disorganized, more manageable. The regulators prefer homogenization, and consolidation is one way of getting things homogenized.

Of course, none of this makes the financial system any more robust. It makes it more fragile and more likely to require—and receive—taxpayer relief. And that’s another problem with the growth of the largest hedge funds—they will increasingly be able to call upon the government for favors. Investors will perceive this advantage, and pour even more money into the rising behemoths.

We’ve already seen this movie on Wall Street. We know how it ends. Why on earth are we replaying the plot with hedge funds?

___________________________________________________

Questions? Comments? Email us atNetNet@cnbc.com

Follow John on Twitter @ twitter.com/Carney

Follow NetNet on Twitter @ twitter.com/CNBCnetnet

Facebook us @ www.facebook.com/NetNetCNBC

NetNet TV

Wall Street