New Orleans is (in)famous for being a party town that seems to inhabit a parallel universe — what happens on Bourbon Street usually stays there, however wild. Not so, however, in America’s fast-expanding private capital world.
On Wednesday, the New Orleans-based Fifth Circuit US Court of Appeals ruled in favour of six private equity and hedge fund groups to toss out a transparency rule introduced last year by Securities and Exchange Commission. This had required private equity, hedge fund and real estate groups to start issuing quarterly performance and fee reports, perform annual audits, and to stop giving some investors preferential treatment over redemptions and special access to portfolio holdings.
Such concepts have long been standard in public markets. But they are anathema to many powerful private capital players. Wednesday’s ruling has thus sparked jubilation among many financiers — and dismay from progressives and consumer protection groups.
So what should sober-minded investors conclude? There are three key points to note.
First, this saga will underscore the impression that the US judiciary is becoming ever more partisan. After all, the reason the case was brought in New Orleans is that Louisiana is a red state whose Republican leaders are predisposed to dislike what the Democrat-controlled Washington administration does. Two of the three judges in the case were appointed by Donald Trump and the other by George W Bush.
Such legal forum shopping is not new, of course. But the stink of political partisanship in the US is rising today. And insofar as the New Orleans ruling reinforces the sense of a partisan judiciary, it is deeply unfortunate.
The second point is that because Republicans are forum shopping, more SEC initiatives may now be overturned. Recent proposed reforms to Treasury market trading and climate-linked reporting, say, look particularly vulnerable.
This is also unfortunate. Chopping and changing these rules will undermine confidence in the predictability of American policymaking. Moreover, the proposed reforms to the bond market and climate-change reporting are sensible: the former aims to reduce the (very real) risk that the Treasuries market will malfunction; the latter would just echo where most other major countries are heading.
The third big lesson from New Orleans is perhaps the most important: investors of all stripes need to get much savvier about the risks lurking in the private capital world. “Business” and “finance” news tends to focus on public companies which are, by definition, easier to track. But one oft-ignored reality of American capitalism is that private companies have always played a huge role in the economy. Another is that the footprint of private capital has exploded in the past two decades.
The American Investment Council says that the US now has 32,000 private equity-backed companies, employing 12mn, while 34mn Americans have pensions invested in this sector. Meanwhile, FTI Consulting estimates that average returns have been 15 per cent in the past 20 years — 50 per cent more than the S&P 500.
Private capital players argue that tighter regulations would crush those amazing returns and insist they are unnecessary since their investors are highly sophisticated. There is some truth to both points: the high-net-worth individuals who used to dominate the sector could and should understand the principle of caveat emptor; and public company reporting burdens are costly and clumsy.
Indeed, FTI calculates that the SEC’s disclosure proposals run to 650 pages, and points out that “unlike their large publicly traded counterparts . . . most private equity firms and real estate funds typically do not have large in-house compliance departments” to handle this.
But the sector is no longer just about sophisticated rich individuals; the reason those 34mn Americans have their pensions exposed to private equity is that numerous mainstream funds and endowments have recently rushed in. Given that, the SEC’s desire to inject more transparency and protection seems entirely understandable and laudable, particularly since higher interest rates will reduce returns in the coming years.
Of course, there is another way to resolve this problem: the asset owners themselves could now demand better disclosure — or vote with their feet, by leaving. I very much hope that more asset owners now do precisely this; it is the only rational response to Wednesday’s ruling.
But one problem with this scenario — that is, trusting in the power of market forces — is that private capital funds typically have long lock-up periods. Another is that financial history shows asset owners usually only demand basic levels of transparency after, and not before, a disaster hits.
Maybe private capital investors will be wiser this time? After all, the impact of rising interest rates on the business model of private capital is already becoming clear. But unless those asset owners do wake up and demand the type of transparency and fair treatment that the SEC can no longer enforce, some will face nasty shocks in the future. And such post-party hangovers are never pleasant, least of all when they’re unexpected. Just ask any hardened visitor to Bourbon Street.