Catastrophism Versus Darwinism: Dodd-Frank as Climate Change

Grant Thornton has issued an update on the asset management industry, an industry it defines broadly to include hedge funds, private equity funds, and registered investment companies. The paper quotes Grant Thornton’s Winston Wilson saying, “The Darwinian process will undoubtedly ensure the long-term vitality of the industry through an evolutionary cycle of innovative products, increasingly transparent operations and effective stewardship.”

That is an odd metaphor: the Darwinian process? Really? It wasn’t even a very satisfactory parallel in Herbert Spencer’s time, and it seems bizarre now. Even were we committed to drawing our terminology from the world of evolutionary theory, a far better label would be “catastrophism,” in the manner of Baron Cuvier, because the paper effectively paints Rep. Barney Frank (D-MA) and former Sen. Christopher Dodd (D-CT)  as constituting together a meteorite that hit the earth and caused a climate shift.

Well-Adapted Dinosaurs

Yes, the paper maintains that this industry achieved “performance and operational efficiencies” during 2011, which sound like the sort of marginal adaptations that play a large part in Charles Darwin’s writings. .

But it also treats the regulatory environment as an external threat, capable of wiping out even the best adapted of pre-collision dinosaurs. The Dodd-Frank Act puts “private investment advisers and funds … under the watchful eye of the SEC” for the first time, and this paper says that the implementation of the new reform measures is proving a lengthy, and uncertain, process. Further, scary estimates of the costs of compliance with the new regulatory system are “forcing many fund advisers to rethink their growth strategies.” Thus, Grant Thornton tells us that a combination of economic and regulatory pressures “may accelerate fund consolidation in years to come as small firms band together for economies of scale or sell out to larger firms.”

The industry will end up looking like a barbell. There will be small firms on the one hand who have found a profitable niche and who will fly under the radar of the more onerous regulations, and of the consolidating impact of deal makers. On the other hand, there will be large firms, already in place or the coming consequence of those deals, who will prove capable of absorbing the regulatory burdens, relying on “technology and outsourcing to support the institutional-level reporting and compliance processes that are mandated,” and that investors in any case demand even beyond the law’s mandates.  In between those two scales, at the impact site, pickings might prove thin.

The Private Equity Space

In 2010, the private equity industry did continue to raise cash. Indeed, according to Preqin, the buyout branch of the industry alone raised $68.5 billion that year. Real estate oriented funds raised another $36.6 billion.

Such fund raising successes created a pent-up deal demand – the funds want to put that money to work, especially in the developed world.

The barbell shape that this paper finds in the industry generally, it finds specifically in the private equity space. Medium sized firms with “neither the niche nor scale to fall back on” are in severe difficulties, so investors have few options in between the large and the small.

But buy-out deal activity is improving. Global buyout deal value back in 1992 was only a little more than $100 billion a year. At the peak of such activity, in 2006, it was $700 billion. The post-crisis law was lower than the 1999 activity. Since then, there, there has been some increase.

The Hedge Fund Space

Turning to the part of the report that looks specifically at the hedge fund space, Grant Thornton notes that funds of funds have lost ground as a percentage of assets within that space. Funds of funds represented roughly 45 percent of the industry in 2007; that is down to 33 percent now.

Nonetheless, funds of funds will survive. They will need to adapt, by providing investors with “enhanced transparency into the underlying investments and [by] customization which allows them to reduce management and incentive fees.”

Another recent development, at the large-scale end of the barbell, is the trend toward initial public offerings for asset managers in general and hedge funds in particular. There are three benefits here. The managers get a stable capital base, the pre-IPO investors get an exit strategy not subject to gates or suspensions, and the fund as a brand gets a higher profile.

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