34818

HEDGE FUNDS AND PRIVATE EQUITY

Features, diversity, and regulations

Douglas Cumming and Geoffrey Wood

Introduction

Alternative investors have become much more prominent in the global financial ecosystem. Four of the most prominent categories include private equity (PE), hedge funds, sovereign wealth funds, and venture capital. Although none has escaped controversy, the former two have come under particular scrutiny for their possible effects on target firms. PE explicitly seeks to change how the firm is run in terms of scale and scope of operations, extent of assets, work and employment relations, and/or relative debt leverage; interventions form the basis of returns. While hedge funds may similarly promote new managerial strategies, they may also adopt a more hands-off approach, basing returns on the time period of retention of shares; at the same time, aggressive and short-term buying and selling of shares may impact on the firm’s relative well-being and on managerial behavior.

Hedge funds represent an alternative investment vehicle that seeks to secure superior returns; although they have historically engaged in traditional hedging strategies, making use of offsetting investments that seek to compensate for adverse market trends and take advantage of short-term price fluctuations, their main aim is returns, rather than commitment to a particular methodology. Given this, they can invest in almost anything, using a big range of financial instruments, but the primary focus on this review is on when they buy shares in listed firms.

Hedge funds differ from other activist investors in that there is a preference to target more profitable firms (Klein & Zur, 2009). Hedge funds typically increase their relative ownership through the use of debt, derivatives, and options (Clifford, 2008). Unlike PE, they do not usually seek to change quotidian managerial practice, and concentrate on broad questions of corporate governance and control, focusing in on cash flow agency cost issues, rather than longer-term investment strategies (Kahan & Rock, 2007; Klein & Zur, 2009). They are generally subject to considerably less regulation than mutual funds, and investing in them is not open to the general public (Kahan & Rock, 2007). Activist hedge funds are distinct in that not only do they seek to have a closer and more immediate impact on target firms, but they are also associated with longer notification periods for withdrawals and lock-up periods (Clifford, 2008). Activist hedge funds are particularly focused on short-term returns; more controversial is whether such short term is damaging to the long-term good of corporates 349or not (Kahan & Rock, 2007). As with private equity, they are most commonly limited partnerships, with relatively high investment criteria, and with a specified lock-up time frame.

PE represents limited partnerships, raising capital for closed-end funds, with clear strategies for investment (Cumming et al., 2015). PE typically consists of a limited partnership, which seeks to target firms believed to have the potential for releasing greater amounts of value to owners; following takeover, they impose new managerial strategies aimed at achieving this. Although typical transactions involve a complete takeover and delisting of the firm in order to attain this, there are many instances of PE taking part ownership of a firm, with the aim of promoting specific patterns of managerial practice. PE takeovers usually involve relatively high amounts of debt leverage, and often have an envisaged limited period of ownership; thereafter the target firm is sold on.

In this chapter, we review key strands of the literature on both hedge funds and PE funds, and draw out the implications for theory. We begin by documenting the relative research interest in hedge funds and PE funds by reference to data from Google Scholar. Thereafter, we explain differences in hedge funds and PE funds in respect of performance, activism, and diversification. Finally, we offer some insights into regulation of both hedge funds and PE funds, and to the development of theory.

Research interest in hedge funds and PE funds

Figure 18.1 presents Google Scholar trends data from 2000 to 2017 on articles that discuss hedge funds, PE, and both hedge funds and PE.

Figure 18.1      Google Scholar hits to hedge funds and PE

This figure reports Google Scholar hits to “hedge funds” and “private equity,” and “hedge funds” “private equity,” over the years 2000-2017(Q2). The hits are indexed to 2006 at 100. The number of hits in 2006 for each search term is indicated in the legend.

Source: Google Scholar.

350Early research on hedge funds was facilitated by the availability of data from data vendors including TASS and CISDM (Agarwal et al., 2015). However, much of the hedge fund literature focuses on a limited range of topics, centering on rates of return, with some studies exploring fund manager skill, differences in outcomes according to type of fund, their effects on asset prices, and the risks posed to both hedge fund investors and the financial system at large (Ibid.). In contrast, the contradictory findings on work on hedge fund performance represent to a large extent differences in methodological approaches (c.f. Kat & Brooks, 2001; Fung & Hsieh, 2004; Baquero et al., 2005).

There is a considerable, but very heterogeneous literature on PE. In part, this diversity reflects differences in the data individual researchers have been able secure on the latter, but also in terms of definitions (some scholars conflate PE with venture capital), scope, and underlying theoretical assumptions.

Controversies in performance: hedge funds versus PE funds

Hedge funds

There has been a long-standing strand of literature that casts doubt on whether hedge funds perform any better than other investment vehicles, and, indeed, suggests that this is often worse. It has also been argued that there is little evidence that hedge fund managers exhibit exceptional skill. As early as 1999, Brown et al. (1999) evaluated the performance of the offshore fund industry, and found that funds did not always match the stock market, were characterized by high levels of attrition, and that there was little sign of differential managerial skill. A further issue is the relative reliability of voluntary disclosures. Patton et al. (2015) find that hedge funds regularly revise their historical returns; such corrections do not appear to be simply the correction of plausible errors. Moreover, underperforming funds tend to be the worst offenders, regularly making downward adjustments to past performance data. This might suggest the need for closer regulatory scrutiny in this area.

In contrast, Bebchuk et al. (2015) concluded that, even over a five-year time period, hedge funds did not leave firms worse off; again early increases in stock price at the time of the takeover tended to persist, as did stock performance.

Similarly, Brav et al. (2008) argue that when they adopt an activist approach, hedge funds drive higher rates in CEO turnover, operating performance, and returns to shareholders. They further argue that this reflects the extent to which hedge funds represent an effective device for better monitoring of managers and closer alignment with shareholder value agendas. Although they suggest that this effect persists one year after hedge fund intervention, it could be argued that, over a longer period of time, these effects may reverse themselves and leave the target organization worse off.

Edwards and Caglayan (2001) concluded that there was a great deal of heterogeneity in hedge fund performance, and that there was a similar degree of persistence in the track record between superior and poorly performing funds; much of this diversity depends on the investment style of fund managers. However, they argue that fund manager incentive fees represent an important predictor of performance, and that higher incentives result in superior performance in terms of returns; however, it could be argued that this may be detrimental to the medium- to long-term well-being of target organizations.

The findings of Edwards and Caglayan (2001) are echoed by Agarwal et al. (2009), who argue that greater fund managerial incentives – including high water mark provisions, higher fund manager ownership levels, and incentive fee contracts – drive better results, rather than 351incentive fee percentage rates per se. They suggest that when fund managers have higher discretion, they are likely to be more effective (Ibid.). However, there are three limitations to this argument. The first, would be to argue that it is inconsistent to suggest that hedge funds are effective as they help solve agency issues, when at the same time arguing for modes of fund management that might open up a new set of agency problems that weaken the rights and control of investors. The second is that a wider range of incentives may encourage excessive risk-taking. The third is the question of causality; Liang (2001) argues that poor performing funds compensate by charging lower incentive fees, rather than vice versa. Lim et al. (2015) note that in the case of the average hedge fund, indirect incentives were relatively high, but that this was particularly the case in the instance of more scalable, younger funds.

Fung et al. (2015) found that multiproduct hedge funds underperformed single-product hedge funds, but were able to secure higher fee revenues. Hedge fund firms that were able to launch follow-up funds were also able to attract greater levels of investment, and set tougher terms of redemption. This has meant that, despite sub-optimal performance, multiproduct hedge fund firms are becoming increasingly dominant in the hedge fund ecosystem.

Kat and Brooks (2001) found that hedge fund indexes exhibit unusually pronounced levels of kurtosis, and that, when this is taken into account, their properties are much less attractive than a simple analysis in mean variance terms would suggest. How investors approach hedge funds represents very much a product of the tools and techniques they use to evaluate their performance (Ibid.).

There appears to a significant political dimension to hedge fund performance. Gao and Huang (2016) found that a number of US-based hedge funds could gain informational advantages flowing from close ties to lobbyists. This enabled advance information of likely policy developments; hedge funds that were politically well connected exhibited superior performance. While the passing on of political information may benefit a wide range of players in the financial services industry, hedge funds appear particularly well placed to capitalize on such information.

PE funds

The theory and evidence from PE indicates that PE investors may add value through sitting on boards of directors, offering strategic, operating, and human resource advice, and enabling networks of contacts that improve firm performance (Kaplan & Schoar, 2005; Jelic & Wright, 2011). There is not only substantial value added, but also superior selection abilities of PE fund managers through many weeks of due diligence (Cumming & Zambelli, 2017). In other words, there are both selection and value-added effects, and empirical studies in PE control for selection effects when assessing the value of the advice provided to investee firms.

In addition to the varying effects of different fund types, an important variation in performance outcomes may reflect how PE fund managers report the performance of deals not yet sold to institutional investors. That is, PE investors typically invest two to seven years prior to selling their investments as IPOs, acquisitions, or secondary sales. Early work presumed that the yet-to-be-sold deals were reported at cost (Kaplan & Schoar, 2005). However, as first shown at the deal level (Cumming & Walz, 2010) and confirmed at the fund level (Phalippou & Gottschalg, 2009), PE fund managers often exaggerate the performance of their yet-to-be-sold investments in order to improve their fundraising success for their follow-up funds. Cumming and Walz (2010) provide empirical evidence that this effect is more 352pronounced in countries with poor legal and accounting standards, among first-time fund managers, and for deals that are more opaque such as high-tech and early-stage deals where there are more plausible alternative explanations for value changes.

Investor activism: hedge funds versus PE funds

Hedge funds

It could be argued that hedge funds have much more effect on firms in terms of their ability to readily buy shares or exit, than in terms of seeking control; in many instances, they appear to exhibit non-confrontational approaches to managerial teams (Brav et al., 2008). However, in recent years, there has been a trend towards hedge funds assuming a more activist role (Coffee & Palia, 2016). On the one hand, it could be argued that more activist hedge funds provide an effective mechanism for representing the interests of smaller and more dispersed shareholders; on the other, it could be argued that such activities are disruptive, without adding to value (Ibid.). Coffee and Palia (2016) concluded that activist hedge funds added to the productivity and performance of target firms, but diminished the stockholder wealth of average competitors. However, when rivals faced a high threat of a hedge fund intervention, then they upped their own game and seemed to respond effectively to such challenges. They noted that these effects were particularly pronounced in dispersed industries and those with low entry barriers (Ibid.).

Aslan and Kumar (2016) similarly encountered significant industry-wide spillover effects among competing firms in terms of productivity, market share, and returns. Nonetheless, they found much diversity in such spillover effects reflecting considerable differences in post-activism changes in managerial practice and the relative competitiveness of the industry in question (Ibid.). Interestingly, financial markets appeared to anticipate spillover effects and reacted accordingly (Aslan & Kumar, 2016). However, it could be argued that spillover effects may deflect firms to greater short termism, and to adopt measures such as share buybacks that may burden the corporation with unnecessarily high levels of debt.

Brown et al. (2001) argue that a key issue with hedge funds is not only rate of return but also the risks associated with them. Past performance may provide some measure of risk, but fund survival also depends on the levels of volatility and the age of funds. As is the case with PE, it may be that superior performance by a limited number of larger established players may eclipse weak performance by a larger number of smaller funds with less experienced managers. Jagannathan et al. (2010) argue that path dependence in fund performance is more closely associated with superior performing funds than inferior ones; the latter are rather more volatile in how they do.

Indeed, Amin and Kat (2003a) find that smaller and weaker performing funds have relatively high failure rates, as is the case with heavily leveraged funds. Given this, funds of hedge funds also yield relatively inferior results. Again, as fund of funds impose a double fee regime, they generally represent a poor investment (Amin & Kat, 2003b). As an asset class, this would suggest that survivor bias may result in the systematic overestimation of returns and the underestimation of failure, leading to an over-allocation of investment capital into hedge funds (Amin & Kat, 2003a). Indeed, Amin and Kat (2003b) argue that at best, hedge funds have a mediocre risk-return profile. Again, writing as early as 1999, Edwards (1999) argues that existing risk management policies were ineffective in taking account of real levels of risk and argued for more stringent regulation; however, it could be argued that subsequent regulatory interventions remain insufficiently robust.

353Goetzmann et al. (2003) find hedge fund performance fees are particularly lucrative to money managers, and may constitute quite a high claim on investor wealth. Bessler et al. (2015) concluded that, in Germany, hedge funds increased shareholder value, but this was through taking advantages of opportunities in weakly governed firms; however, the performance of more aggressive funds was poor, and they conclude that they sought to expropriate existing shareholders by exiting at temporarily induced share price peaks.

Liang (2001) concluded that through the 1990s, hedge funds yielded inferior results when compared to the S&P 500. Again, although over the decade, the S&P was more volatile, the effect of shocks in global financial markets was greatly magnified in the case of hedge funds. In looking at the 1990s and 2000s, Boyson et al. (2010) find similar evidence that hedge funds are particularly prone to contagion; again, they argue that while liquidity shocks severely affect hedge fund performance, these shocks are not properly captured by existing ways of modeling hedge fund returns. Getmansky et al. (2015) concluded that in the absence of lock-ins, the performance of hedge funds was broadly similar to mutual funds.

A major limitation of the existing literature on hedge funds is the primary focus on rates of return; there is very much less on how hedge fund activities may affect the firm, managers, employees, and other stakeholders (c.f. Baquero et al., 2005). A rare exception is that of Brav et al. (2015); they conclude that investments by hedge funds improve productivity, particularly through an overhaul of business strategies. However, this is also associated with a stagnation in working time and wages; they suggest that a major cause of value release is the redeployment of capital. In looking at the impact of activist hedge funds on innovation, Brav et al. (2016) found that target firms improved their relative innovative efficiency; even if R&D expenditure was tightened, innovation appeared to increase. This seemed to be neither the result of the effective stock picking by such funds nor voluntary changes in managerial practice (Ibid.).

Shawky et al. (2012) show that there is a positive relation between hedge fund performance and diversification across sectors and asset classes. However, diversification across geographies does not have a significant impact on hedge fund performance, and diversification across styles (“jack of all trades” fund manager) negatively affects hedge fund returns.

PE funds

In the context of PE, Knill (2009) shows that pure play strategies are bad for performance, and likewise excess diversification is also bad for performance. As such, it is important for institutional investors to clarify the fund strategy and goals at the time the fund is established.

As with the hedge fund ecosystem, there is much diversity within the PE ecosystem. While there are many different types of fund, according to sources of funding, sectoral focus, and the types of organization they target, a key distinction first of all, is whether the fund is venture capital or PE per se (Wood & Wright, 2009). Although these two categories are often conflated (Wood & Wright, 2009), there are a number of key distinctions between them, and this will impact on the type of practices they impose on target firms. While both types of investor seek to change or enhance particular managerial practices, a key distinction is that, in the case of venture capital, the target firm is one that is early in its organizational life cycle, and, hence usually with a more limited range of assets against which debt can be leveraged (Gompers & Lerner, 2004). Venture capital targets relatively new firms with potential for success, and seeks to strengthen managerial capabilities (Sahlman, 1990). While promising start-ups may have excellent business concepts and/or be highly innovative, they often lack experience of the practicalities of management in a particular industry 354(Gompers & Lerner, 2004). The latter is the value added by the venture capitalist, who typically enters into a co-ownership arrangement with the original entrepreneur; typically, VCs retain some equity stake after the IPO, and retain board seats on portfolio firms, maintaining an effective monitoring role (Barry et al., 1990). It could be argued that venture capital has the potential to make a real contribution to the attainment of organizational ambidexterity, supplementing the explorative knowledge and capabilities of the original entrepreneur with exploitative knowledge and capabilities (Hill & Birkinshaw, 2006). Given the strong interest of governments and regional development authorities in supporting new business development, there have been numerous incidences of direct or indirect state support for venture capital (Jeng & Wells, 2000). Again, this has made venture capital much less controversial than PE; trade unions are often hostile to the latter, but can be much more accommodating of the former (Coe et al., 2004). Although it is recognized that venture capital represents an important component of the alternative investor ecosystem, for the reasons set out earlier we remain convinced that it should be treated as quite a distinct category to PE. However, at the same time, we are skeptical of the view that venture capital is always benign, and PE similarly malign. Not only are there several different types of PE fund, but venture capitalists vary greatly in terms of their relative effectiveness and outcomes. As with any type of investor, venture capitalists are by no means uniformally competent. Small players may lack sufficient capital to make a real difference, and inexperienced ones may similarly lack access to networks and the managerial expertise to enhance the performance of target firms and/or be over-stretched in terms of the demands placed on them (Hochberg et al., 2007). Indeed, it could be argued that the chain saw principle holds true; just because an individual is possessed with such a device does not make her/him trained or equipped to perform tree surgery, undocumented claims of such a status or capability notwithstanding. Again, by no means all venture capitalists have the knowledge, resources, or competence to make a positive difference, despite the positive aura attached to the title. However, the primary focus of this review is on PE, given, as with hedge funds, the degree of interest and controversy their activities have attracted. On the one hand, it could be argued that PE tends to treat organizations in an overly instrumental fashion; as vehicles from which value can be captured, taking excessive debt and selling off assets, benefitting financial intermediaries who risk a relatively small part of their own capital, yet leave stakeholders and the target firm very much worse off (Folkman et al., 2007).

Within the broad PE category, an important distinction is between managerial buyouts (MBOs), managerial buyins (MBIs), and institutional buyouts (IBOs). Again, there is a regrettable tendency in strands of the literature to conflate these categories when there is evidence of very different core principles, focus, and outcomes (Wood & Wright, 2009). In the case of MBOs, an existing managerial team works with PE to take over an existing organization, typically ending up owning a significant component of equity, using debt to access further finance (Wood & Wright, 2009). Not only does this resolve any agency challenges, but existing managers bring with them their detailed knowledge and understanding of a particular firm and industry; it is also easier for them to accurately cost the worth of their human assets. Bacon et al. (2004) concluded that such MBOs brought with them new possibilities to forge entrepreneurial deals with staff, unlocking human potential. Based on industry wide survey evidence, they conclude generally superior outcomes in this instance.

MBIs represent an outside managerial team working with PE, again to take over an organization, making usage of debt leverage, with a view to bringing about changes in practice. They may infuse new managerial skills when the existing management team is weak, but excessive debt may bring with it problems of its own. In comparing MBOs and MBIs, 355Robbie et al. (1992) found that MBIs tended to perform worse than MBOs, given that it was easier for outsiders to misjudge the problems facing the target firm. Robbie and Wright (1995) argue that although MBIs may result in an optimally incentivized managerial team, there are challenges in ensuring the optimal mix of entrepreneurs and firms, monitoring, and strategy implementation. There is, once more, the possibility of the chain saw principle: a self-professed manager may or may not have managerial expertise and industry relevant knowledge and capabilities. It is likely that such takeovers would lead to a rebalancing of the resources accruing to managerial vis-à-vis line staff (see Brewster et al., 2017).

In the case of an IBO, a PE partnership takes over a firm and either replaces the existing managerial team, or subordinates it to a new agenda; typically, managers do not own significant shares (Goergen et al., 2014). Also typically, the process involves heavy debt leverage. It is this category of takeover that has become controversial. As those controlling firms are outsiders, it is easier to renege on implicit contracts (Shleifer & Summers, 1988). In comparing IBOs with a control group of firms, Goergen et al. (2014) found that over a five-year period, employment, productivity, and performance dropped vis-à-vis the control group. They ascribed this to an inability of outsiders to accurately cost the worth of a firm’s human assets and their capabilities as a collective. While restructuring may enable the leverage of further debt and the liquidation of assets, this appears to negatively damage sustainability of the firm.

There are a number of general critiques of PE; typically such studies make usage of limited panels of case studies (Froud & Williams, 2007a, 2007b). Again, this work concludes that employees and other stakeholders tend to be left very much worse off, even if value is released in the process. A focus on high returns encourages repressive HR policies, with there being many documented examples of PE-owned firms following this path (Clark, 2007). Ernst et al. (2013) suggest that target firms are often overvalued, as the primary aim is to liquidate accumulated assets.

There are two strands of thinking that see more beneficial effects. The first suggests that job cuts represent a positive sign, demonstrating that excessive managerial empire building is reigned in, and the sale of assets leads to capital being redirected to more optimal paths (Jensen, 2006). Again, Baker and Anderson (2010) argue that PE may introduce a much needed objectivity into managerial processes, and a clearer focus on the bottom line. A second strand of thinking suggests that within specific types of takeover, the employment effects may be positive, rather than negative, and, indeed, employees may benefit from the efficiencies released by reduced agency costs (Bacon et al., 2010). However, Bacon et al. (2013) note that the PE ecosystem is a diverse one, and that not all PE investors have short-termist investment horizons.

Regulation of Hedge Funds and PE Funds

Table 18.1 summarizes a number of studies pertinent to the regulation of hedge funds and PE funds. In respect of hedge funds, early theory (Verret, 2007) and evidence (Brown et al., 2009) from the US shows that there can be value to mandatory registration of funds and simple due diligence screens that investors can put onto funds. In particular, the due diligence that is possible with a simple form ADV in US registration enables substantial performance improvements with hedge funds (Brown et al., 2009) by not investing into funds that have more pronounced operational risk, such as having a prior criminal record. However, this registration requirement is not the only thing that should work in theory, as there could be components of self-regulation that might enhance the value of registration and disclosure (Verret, 2007). Early work by Brav et al. (2008) shows that activist funds have substantial improvements in the financial performance of investee firms, but other work has questioned the effects on other firm stakeholders (Coffee and Palia, 2016).

Table 18.1      Overview of studies on hedge fund and PE fund regulation

356

357

358

359

360

361

362

363

364

365

366Cumming and Johan (2008) and Cumming et al. (2013) show that there are substantial differences in the ways in which hedge funds are regulated around the world, including restrictions on the location of key service providers, permissible distribution channels, and minimum size requirements. However, they also show that hedge fund managers are not subject to a “race-to-the-bottom” in the sense that they pick the jurisdiction with the worst regulations to enable more pronounced agency problems associated with their fund.

Bollen and Pool (2008, 2009) show that hedge funds misreport returns from month-to-month in order to avoid reporting negative monthly returns, thereby improving their capital flows into the fund. This misreporting is more pronounced among funds registered in jurisdictions with wrapper distributions where performance is less clear-cut as financial products are comingled with one another (Cumming & Dai, 2010b). Also, this misreporting is more pronounced when there are restrictions on the location of key service providers, as it appears that such service providers are of lower quality in jurisdictions where these restrictions are in place (Cumming & Dai, 2010a). Restrictions on location and wrapper jurisdictions further enable capital flows into worse performing funds (Cumming & Dai, 2009) and the persistence of poor quality of funds over time (Cumming et al., 2012). Within the US, evidence is consistent with the view that Delaware hedge funds have substantial advantages in respect of the clarity of obligations with their institutional investors, albeit there are no differences in overall performance (Cumming et al., 2015).

A few studies have examined the impact of Dodd-Frank legislation on US hedge funds. Early work from a sample of nine months in 2012 shows no discernible impact of US hedge fund performance (Kaal et al., 2014). However, more recent evidence with a longer time period from 2007 to 2015 shows that funds subject to Dodd-Frank have lower returns, but also low risks (Cumming et al., forthcoming).

PE funds have experienced relatively scant regulation in the US. The dearth of regulation appears to be appropriate, as there is substantial evidence showing that PE funds achieve substantial returns (Kaplan & Schoar, 2005) and value-improvements with investee firms (Wright et al., 2009; Jelic & Wright, 2011), with few scandals or other investor harms.

Some European countries, by contrast, have imposed substantial regulations on PE funds, and overall, the evidence shows these regulations have not enhanced the quality of the market (Cumming & Zambelli, 2010, 2013, 2017; Renneboog & Vansteenkiste, 2017). In Italy, for example, LBOs were prohibited from 1999 to 2004, which in turn did not eliminate LBOs but instead changed their deal structures and the activist investment that could have brought about improved deal values (Cumming & Zambelli, 2010, 2013, 2017).

Comparing across countries, regulatory systems that protect investors, particularly creditors in LBOs, are important to PE investors (Cao et al., 2015). Likewise, institutional investors are made better off by legal and accounting standards that improve reporting quality of PE funds (Cumming & Walz, 2010). The bulk of the literature on PE takeovers has been conducted in the US and the UK. Important exceptions are represented by Bacon et al. (2012) and Boselie and Koene (2010). The former suggested that overseas investors did adapt to realities in the host institutional regime. Meanwhile, the latter found that PE from liberal markets appeared more likely to introduce hardline HRM policies into coordinated ones (Boselie & Koene, 2010). In looking at PE takeovers in France, Brewster et al. (2017) found job losses when foreign PE was involved; however, French PE appeared to behave the same way as any other French investor. They ascribe this to the active state role in the 367indigenous PE industry, which promotes the kind of takeovers that would support regional development objectives (Ibid.).

Theoretical implications

Agency approaches would view hedge funds and PE in a broadly similar light, in that both represent mechanisms for solving agency problems and realigning managerial interests with owner agendas (see Jensen, 2006). Downsizing or debt leverage would be viewed as releasing capital to more productive paths (Ibid.). There are three broad limitations to such approaches. The first is that there is a conflation of the interests of property owners and intermediaries; however, as the earlier review of hedge fund activities would suggest, these cannot always be conflated. The second is that investors may have quite diverse agendas; not all will operate according to the same time periods; this is reflected, for example, in the different manifestations of PE. The third is that it accords insufficient attention to context (albeit that developments of such approaches recognize the effect of institutions on the choices made by actors; La Porta et al., 2000). However, empirical evidence would suggest diversity and that this is bound up not just with formal regulation, but also informal conventions and the density of ties between key players (Deeg & Jackson, 2007; Wood et al., 2014).

An alternative, socio-economic explanation would be to recognize common features of the global financial ecosystem, but be skeptical of the possibility of a single optimal path in regulation or practice (Wood et al., 2014). In turn, this would suggest that any category of investment may have beneficial and negative consequences, but that in specific settings and times, some may result in much better (or worse) outcomes than others. Although the relationship between institutions and social action remains an open-ended debate, we would argue for a more nuanced understanding not only of the former, but also of the latter. As noted earlier, there is an informal dimension to institutions and associated rules (Hollingsworth & Boyer, 1997; Deeg & Jackson, 2007; Wood et al., 2014). Again, although it is increasingly recognized that rational action is bounded, there remains a tendency to see agents as broadly competent in seeking to realize their agendas. Much diversity in the outcomes of both hedge funds and PE would suggest that competence is sometimes lacking, that poor performing funds may still succeed in attracting investments for sustained periods of time, and there remains an element of uncertainty as to what might be the optimal intervention in any setting. Finally, as the checkered progress of PE in Germany and hedge funds in Japan would evidence, the viability of particular alternative investment strategies depends a great deal on how other players in the financial ecosystem respond to them.

Conclusions

Hedge funds and PE funds are active value-added investors that show massive performance potential but also substantial differences in performance across funds. Unfortunately, delegated asset management through hedge funds and PE funds involves a number of potential agency problems. These agency problems include, but are not limited to, misreporting fund returns to investors in hedge funds (Bollen & Pool, 2009) and PE funds (Cumming & Walz, 2010). The evidence in this chapter shows substantial value associated with investors that carry out due diligence before investing in these funds (Brown et al., 2008), and value associated with regulations that enable transparency and better monitoring. The evidence reviewed in this chapter provides insights into the similar economics underlying hedge funds and PE funds. As these funds evolve over time and around the world, there will be significant 368opportunities to explore additional empirical issues with measuring the costs and benefits with delegated asset management under different institutional contexts.

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