A company is not a ‘bag of assets’

Poul Nyrup Rasmussen has been pressing for a regulatory clampdown on private equity and hedge fund

Poul Nyrup Rasmussen

managers in the European Union for a number of years. As the former prime minister of Denmark he witnessed the controversial €13 billion take-private of Danish telephone operator TDC by a consortium of financial sponsors in 2006. In his current position as president of the Party of European Socialists, his efforts to curtail the proliferation of “risky” investment products have garnered support among colleagues in the European Parliament. Draft regulation – in the form of the EU’s Alternative Investment Fund Managers Directive directive – was created last year and has since been the subject of constant, heated debate. The directive is currently being revised and amended before being put to the vote in the European Parliament in July. In an exclusive interview, PEI finds out whether his stance has softened.

PEI: Do you accept that in many respects private equity fulfils an important role in the economies of Europe?

Poul Nyrup Rasmussen: Only a portion of private equity activity, that is venture capital, has positive economic and social externalities, in that it supports innovation. If we are to achieve the transition of the EU towards the Lisbon Strategy goals – now the 2020 goals – we need efficient mechanisms to fund risky projects with very high growth potential. So I fully support the development of venture capital, and I believe we should be thinking of how public authorities could boost these activities, not only through regulation but also through public funding.

“Classic” private equity activity – that is the largely predominant buyout segment – is mostly detrimental to the economy. A business model that relies on extracting value for the benefit of a few, as opposed to creating value for the benefit of many, cannot deliver efficiency at the macro-economic level. A company is not a “bag of assets” that can be dismantled for the sake of short-term returns. I have seen too many healthy companies being badly disrupted by useless LBOs to be enthusiastic about the whole thing, to say the least.

PEI: How much is your push to curb the activities of private equity and hedge funds the result of the TDC buyout?

If  we don’t change the rules of the game today, we will face the same problems tomorrow. We simply cannot accept that.

Poul Nyrup Rasmussen

PNR: The TDC case is only one story among many others. We have been working on this issue for many years, with all our European and American friends. It is a fact that the overloading of debt has weakened the companies concerned. And this is why private equity has to be regulated.

PEI: Given that large, highly leveraged buyouts like TDC are off the agenda for the moment, do you still believe that regulation is needed?

PNR: Maybe another mega-buyout seems impossible today, but what about tomorrow? Obviously the markets are still recovering from the downturn, and there is still a lot of deleveraging to come, writedowns to be offset, etc. But it would be very short-sighted to just assume that the market conditions will remain the same. With the economic recovery, markets will rebound, cash will flow again, leverage ratios will increase, new bubbles will inflate, until it all collapses again and we undergo another massive crisis … unless we do something now. It might be in two or in 10 years, but if we don’t change the rules of the game today, we will face the same problems tomorrow. We simply cannot accept that.

PEI: How would you respond to criticisms that the AIFM draft has been drawn up too quickly?

PNR: I can assure you that it hasn’t. An expert group on [alternative investment funds] was set up by the European Commission four years ago, kicking off the normal EU legislative process. In the EP [European Parliament], I presented a report recommending the Commission come up with a proposed directive in September 2008. This was largely drawn from previous work, notably a report drafted with the socialist group at the EP in March 2007. Since then, the Commission’s first proposal has already undergone two revisions, and is far from being adopted. So you can see that no one is rushing such an important matter.

PEI: Private equity industry associations are concerned the directive will hurt them and their portfolio companies at the worst possible economic time.

PNR: First of all, the political cycle and the business cycle are not synched. The crisis helped us to gain momentum for reform, it is now urgent to seize this opportunity if we want to avoid a repetition of the crisis. When the US Glass-Steagall Act was implemented in 1933 it was a pretty tough time for financial actors, too. But it had to be done and could be done at that moment. And it worked, in providing nearly 40 years of financial stability.

My second point is that the very reason why private equity firms are at the worst possible time today, is because we lacked the appropriate regulation prior to the crisis. A directive like the AIFM would have helped prevent some of the overleveraging and pro-cyclicality that have made the downturn so deep.

Finally, there is also a bright side in this new regulation for market players: if the ‘EU passport’ makes it to the final text, the industry will benefit from a single private placement regime, making it easier to do business. You need to consider the new investment opportunity that will be generated by the new framework.

PEI: Costs incurred will ultimately be handed on to the funds’ investors, which are comprised mainly of pension funds. Is this something that concerns you?

PNR: That’s a disingenuous statement! If a fund wants to invest in a risky product, it will have to pay the price for it. And it is rather healthy that the cost of risk is corrected upward. Don’t forget that the crisis started because of unexpected default – for the very reasons that risk had been underestimated and consequently undervalued for too long.

And furthermore, should pension funds really invest in risky, [alternative investment fund] products? Should institutions that are being trusted by millions of people to deliver them a means of existence once they are retired be allowed to gamble hard-earned savings? People who invest in pension funds should know what they’re getting. If some of them wish to take more risk for potential higher returns that’s fine by me, but I don’t think you can claim it was the rational choice of the thousands that lost everything in the crisis.

PEI: As it stands, the directive could catch real estate and infrastructure funds in its net. Do they really need to be regulated?

PNR: Yes they do. All financial institutions must be regulated in order to shut down for good the shadow financial system. It does not mean they are the same – in fact we acknowledge the great differences between the various types of institutions. But all AIFs share a number of common characteristics, the most important by far being a general lack of transparency. This calls for an “all encompassing” approach.

PEI: Private equity often raises its compensation model in its defence as incentivising genuine long-term performance. What are your thoughts?

PNR: I would not personally be too proud of being a “genuine long-term performer” by extracting revenue and imposing a short-term view on the companies that I’d managed. This is in my opinion a very poor line of defence, because the higher the carried interest on profit above the hurdle rate, the greater the incentive is for the manager to operate in a way that has great negative economic and social externalities.