Vol 10 (2013) - Issue 5

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The Regulation of Private Equity and the Alternative Investment Fund Managers Directive – Part III

This article is a continuation of the discussion set out in a previous contribution to this volume, essentially looking at the impact of AIFMD with respect to the three main negative externalities potentially created by private equity. Following the analysis in the previous two parts of specific stakeholders in isolation – namely employees of portfolio companies and investors – part III below accordingly addresses the most serious case in favour of regulating private equity: to prevent systemic risk. However, the arguments in favour of regulation are largely based on the risks posed by the hedge fund model, many of which do not necessarily apply to private equity. It will be seen that the AIFMD’s focus on a broad class of 'alternative investment funds' obscures this distinction, leading to overregulation.

Part III: Systemic risk
A. Defining systemic risk and the ways in which systemic risk is created
Following the financial crisis, political and academic debate has focused attention on systemic risk, the sources of such risk, and the ways in which risks can become systemic. For the purposes of this discussion, it will be useful to establish some working definitions.
There is no single agreed-upon definition of systemic risk. This is likely to be because the concept is not yet well understood by economists or policy makers. A wide definition has been adopted by the Financial Stability Board and the European Systemic Risk Board. The underlying concept is a 'risk of disruption in the financial system with the potential to have serious negative consequences for the internal market and the real economy.' The usefulness of such a vague definition is obviously limited, so risk sources and risk transmission must also be considered.
The sources of risk can be numerous and, again, there is no settled view on just how numerous. Lo has identified 'four Ls': leverage, linkages between firms, liquidity, and losses across the financial system. The Securities Industry and Financial Markets Association adds several more to this list. These risk sources are not mutually exclusive, and while this discussion will focus primarily on liquidity and leverage as sources of risk, it will be clear that the size of, and linkages between, firms will strongly affect the significance of these risks.
Nor are the means by which risk is transmitted to the internal market and the real economy free from contention. Broadly, however, three main ways can be identified. Firstly, counterparty contagion occurs where the failure of a firm directly leads to the failure of other firms, e.g. customers, suppliers, lenders and debtors – similar to a domino effect. It is in this way that the sources of risk focused on in this discussion are usually transmitted. Secondly, informational contagion exists where the failure of a firm erodes market confidence in other firms, perhaps in the same industry or region. These other firms may fail when they are no longer able to obtain financing or conduct transactions on viable terms. Finally, a common shock is an unpredictable event that impacts an entire industry or economy. For example, the 11 September 2001 attacks were a common shock to the airline industry, which was obliged to ground operations in the US for three days.