Hedge Funds do exactly what the name implies: They hedge. Most are out of the reach of the average investor with some having minimum investment requirements of $100,000 and provable liquid net worth requirements of $1.5 million or more. For the most part, a hedge fund seeks a consistent return regardless of market direction. They often seek high yield fixed income instruments and can employ sophisticated options techniques as well as futures, derivatives, short sales of equities, arbitrage techniques, offsetting long and short positions, commodities trading and currency speculation.
The main troubles of late seem to have risen from the purchase of complex debt instruments like the "CDO" you may have heard about recently. The dangers occur when they (the CDO) is employed on a large scale because the instrument can be and often is highly speculative. If they stayed the hell out of the public markets, it might not matter that much but they don't and since most Hedge Funds have strict entry requirements for investors, they can take much more risk than say, a typical Mutual Fund. They can have an enormous effect on a particular segment - home loans, for instance - if billions are injected into a segment of a market that otherwise would not have attracted such large sums. Hedge funds are not going to go away but their appeal may very well diminish if the risk vs. reward gets to be too much, even for a very wealthy client.
Private Equity is also, just that - equity sources that are not publicly traded. Remember the movie "Pretty Woman"? The Richard Gere character ran what was essentially a PE type firm. Private Equity funds and firms have no obligation to disclose to the public their balance sheet. They are private, after all. Again though, just like Hedge Funds, they often purchase publicly traded companies and securities, and it seems the fashion of late (last 3 years or so) has been the high yield market provided by mortgage securities. To truly understand how and why these instruments have caused so many problems, it is important to understand how they are created in the first place. For simplicity, I am going to quote from the Wikipedia page on "Collateralized Mortgage Obligations"
http://en.wikipedia.org/wiki/Collateralized_mortgage_obligationThe most basic way a mortgage loan can be transformed into a bond suitable for purchase by an investor would simply to be to "split it". For example, a $300'000 30 year mortgage with an interest rate of 6.5% could be split into 300 1000 dollar bonds. These bonds would have a 30 year amortization, and an interest rate of 6.00% for example (with the remaining .50% going to the servicing company to send out the monthly bills and perform servicing work). However, this format of bond has various problems for various investors
Those problems are enumerated further in the linked article so i wont go into them here, suffice to say, the riskier the underlying mortgage, the riskier each and every one of those 30 bond issues mentioned above become. The higher the risk, the higher interest rate demanded by the market and thus the higher yield provided to the investor. Since the 2 major factors that drive markets are fear and greed, the search for ever higher yields fueled the availability of this "cheap money".
The other area in which PE firms cause concern is the "Leveraged Buyout" wherein the credit of the firm is used to borrow money to fund the purchase of a publicly traded company and hence, take it private. If you own the controlling majority of the shares of General Electric, for instance, the company is essentially yours to do with as you please. This is not always a bad thing. An example is the purchase of Detroit Diesel Corporation from General Motors in the late 80's by Roger Penske. GM was on the brink of closing the doors at DDC because they had about 10% or so of the heavy diesel engine market and they had notoriously leaky engines and antiquated designs. Penske removed that asset from GM's books, took it private and was able to turn it around so effectively that by 1993 initiated an IPO and put DDC on the New York Stock Exchange. By 2000, Mercedes Benz saw DDC as being so attractive they bought it. This exercise saved several thousand UAW jobs and turned what was a dinosaur of an engine company into a world leader in diesel technology. Roger Penske bought himself a 153' yacht in 2003. Personally, i think he deserves it.
The downside to the LBO is when a company is purchased and split up for parts, basically and the employees and company name suffer.
LBO's aren't going to go away either but the recent headlines regarding both PE firms and Hedge Funds are likely to force Congress to ensure the SEC has the teeth to force more disclosure and financial reporting. Like i said at the top, they have brought more attention to themselves than they probably wanted, but this is a good thing for the markets in general.
Damn! That was rather long winded! Was there an opinion in there? In short, PE firms and Hedge Funds have their place but if their effect on the markets and economy at large becomes too great, they should be subject to exactly the same regulation everyone else has.
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