Private Equity and Hedge Funds: The Shadow Capital Market

December 2008

Private Equity and Hedge Funds: The Shadow Capital Market
Abstract of an Advisen Whitepaper

Private equity firms and hedge funds have seen stellar growth over the past decade, riding the wave of easy credit and eager investment pools. Together, they have represented a shadow capital market, providing investors an alternative for investing and trading, and in the case of private equity offering businesses access to capital. But in the aftermath of the credit crisis lays deep trouble for these firms, as the deleveraging of the global economy removes a vital ingredient to their success.

Private equity firms and hedge funds have a history of making media splashes, running the gamut from financial golden-children to the bane of Wall Street, and recent years have been no exception. Dating back to the middle part of the 20th Century, these funds have produced out-sized returns for many investors and devastating collapses for others. The collapse of Bear Stearns in March 2008 was directly tied to the meltdown of the hedge funds they managed. For the first time, the failure of hedge funds brought down stakeholders other than fund investors, dragging down with them a venerable investment bank and causing market-panic.

Companies hungry for capital have grown to love private equity as a valuable alternative source, while resenting the degree of control relinquished in exchange. Hedge funds are often a stabilizing force in markets, improving efficiency through rapid trading and arbitrage, while being the source of scorn for instigating speculative rallies and cannibalizing their financial brethren on the down-swing. During the recent market sell-off of commercial and investment banks, hedge funds were accused of naked short-selling, which is short-selling without being in possession of the shares sold. The crushing blow experienced by these stocks prompted the SEC to ban such practices. These seemingly incompatible images have led to a high degree of interest and concern from investors, corporate executives, regulators, politicians, the media and the general public.

This Whitepaper was written by John W. Molka III, CFA, Senior Industry Analyst and Editor, 212.984.2753, jmolka@advisen.com.