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Current Regulations Give Banks No Downside
Large banks need more equity to stabilize the financial system
Ever wonder how private equity shops can generate such impressive internal rates of return? The answer is mezzanine debt.
When PE funds make a purchase, it is typically a combination of equity and debt financing. Debt comprises the largest portion, and is usually sold to investors looking for a low-teen return with commensurate risk. The small portion that remains is equity, and PE funds usually keep that for themselves. If the return of the investment is greater than the interest rate of the mezz debt, the balance goes to equity holders – and since there isn’t a lot of equity, returns can be quite extraordinary.
This is the same way financial institutions are being managed today. A recent article on Goldman Sachs does a great job describing how banks are incentivized to finance much of their capital markets activities with debt, so that their return on equity can be astronomical.
This goes a long way in explaining why Wall Street compensation is off the charts. After all, if things don’t go as they should, banks can just get bailed out – in a way, using the U.S. government’s balance sheet as a backstop. From a risk-return standpoint it’s a great trade, but from a moral hazard standpoint it’s a disaster. The bottom line: More equity in large banks is needed to further stabilize the financial system.
About the Author
Ben Warwick, Quantitative Equity Strategies
Veteran investment strategist Ben Warwick brings 20 years of investment management expertise to AdvisorOne.com in his blog, Searching for Alpha. His market and economic insights provide readers with an insider’s view on generating alpha through asset allocation, the use of strategic portfolio “tilts” and alternative investments.
Ben Warwick founded Quantitative Equity Strategies (QES) in 2002 as a platform for implementing his quantitative investment strategies. The firm manages assets with traditional long-only equity and fixed income, private equity, managed futures and alternative investment mandates. QES has developed an industry leading expertise in building investment programs that can replicate alternative returns, while offering daily liquidity and transparency. These products include the HFRq, a hedge fund replication strategy developed in concert with Hedge Fund Research in Chicago; the Managed Futures Beta Index, with Aspen Partners; and the Nomura QES Modeled Private Equity Returns Index (PERI), which was developed with Nomura Bank and Preqin, the leading source of information in the private equity industry.
He is the author of several books, including "Searching for Alpha: The Quest for Exceptional Investment Performance," (Wiley, 2000) and "The Handbook of Managed Futures," with Carl Peters, (McGraw-Hill, 1996). He can be reached at ben@qesinvest.com.
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