Dodge on private equity
Private equity has raised more concerns on the other side of the Atlantic than in North America. Andrew Jackson made some comments on the topic on RPE a month ago. Whether David Dodge has been dropping in on RPE is not clear (we will FOI his browsing history), but at any rate, it is welcome for him to weigh in on the topic. I’m not sure about his comments about hedge funds, though, as it is not obvious at all to me how highly leveraged speculation in the financial markets reduces volatility.
Bank of Canada Governor David Dodge has signalled his growing concerns about the glut of global liquidity, as the private equity chase to buy public companies picks up speed.
“We do seem to have an inexhaustible supply of debt finance to facilitate … hedge funds or other private pools of capital, to take companies out of the public domain,” Mr. Dodge told MPs yesterday during testimony at the House of Commons finance committee.” That is an issue which, as a central banker, we have to be concerned about.”
The world is awash in fast money, he said, and it is changing the structure of capital markets.
“There seems to be a lot more global liquidity out there than one might have anticipated,” Mr. Dodge said. Spreads of high-risk investments are “pretty narrow” and don’t properly reflect risk, he warned. In other words, issuers of high-risk debt can get away with paying historically low prices to get investors to carry their debt.
That’s because there is so much money chasing a limited number of investment opportunities, driving down aversion to risk – especially for high-risk debt issuers such as companies with junk bond status or emerging market economies. As a result, spreads (a proxy for the price that bond issuers pay investors to carry their debt) have eroded steadily and steeply over the past five years, leading many economists to warn that they are too narrow, and that investors have become complacent. “That is a real issue … a very, very real problem and potentially a real concern,” Mr. Dodge said, especially as private equity firms race to buy up companies and take them out of publicly traded, regulated markets.
In the past, the central bank has said that it is not concerned about the proliferation of hedge funds, saying such investors serve global capital markets well because they diffuse risk.
“On balance, at most times, hedge funds make markets more liquid and efficient,” deputy governor David Longworth said in November. “And in all likelihood, this has contributed to reducing financial volatility, at least in some important markets.”