How Has The Rise of Private Equity Firms and Hedge Funds Increased Wealth Inequality in the United States?

INTRODUCTION

The shadow banking industry has been playing a larger and larger role in recent years to create credit across the global financial system. It has shaped the way we live and interact today. However, a lot of people in America have no idea how unequal the system is. My research explores how hedge funds and private equity firms have increased wealth inequality in the United States. This topic is relevant because the banking system has a large stake in what happens with global markets and trade, and the average person is always affected — whether they like it or not (through loans, market crashes, inflation, interest rates, mortgages, etc.). Unfortunately, in 2020, the socio-economic impacts of COVID-19 have done much to widen the wealth gap even further.

Through the literature I have studied within my major and external research, I hope to deep dive into the world of hedge funds (like Bridgewater Associates) and private equity firms (like Vista Equity Partners) and how they operate. I also hope to look at how this is increasing wealth inequality in the U.S.

KEY ISSUES

Hedge Funds

First, I would like to look at how hedge funds have completely changed the game for investors. Sociologist Alfred Jones is credited with coining the name “hedged fund” and creating the first hedge fund in 1949. Hedge funds try to maximize the return on investment for their stakeholders while minimizing risk, regardless of whether the broader economy is doing well or not. They utilize methods such as short selling, market speculation by complicated financial modeling, and complex derivatives trading.

Hedge funds started flourishing in the 1990s and have grown substantially since then with total “assets under management” (AUM) valued at over $3.25 trillion according to the 2019 Preqin Global Hedge Fund Report. However, hedge funds are an exclusive club, only available to extremely affluent investors — generally those with a net worth exceeding $1 million. Hedge funds also face little oversight from the Securities and Exchange Commission (SEC) compared to other investment management businesses.

Bridgewater Associates, one of the largest hedge funds, is overseen by its billionaire founder Ray Dalio and serves clients worldwide. Bridgewater Associates averaged an annualized return of 12% for its Pure Alpha product line since its creation over 20 years ago. Whereas during the week of September 23, 2020, the average interest rate for savings accounts was 0.09%, and with most Americans’ money in savings accounts nationally, this difference in return is increasing wealth inequality immensely. Therefore, the key issue I would like to highlight is that hedge funds are increasing wealth inequality in the United States by creating a barrier of entry for the average person while creating enormous returns of investments for themselves and their billionaire hedge fund managers.

Private Equity Firms

Second, I would like to explore the world of private equity firms. Private equity firms manage large amounts of money obtained from institutional investors or high net worth individuals (who can dedicate substantial sums of money for long periods of time) to procure ownership of private companies through strategies that include complex leveraged buyouts and venture capital. After obtaining ownership, many private equity firms give mentorship and expertise to the companies to help them grow, then eventually sell the company for a profit or go through an initial public offering (IPO). According to a study led by Harvard University, worldwide private equity groups raised over $2 trillion between 2006 and 2008, and each dollar was leveraged by over two dollars in debt.

The investors in successful private equity firms such as Vista Equity Partners (a private equity firm focused on software and technology-focused startups with more than $57 billion in capital commitments) see large returns on investments. Depending on the deal, private equity firms hope to have a return of two to four times the initial investment in three to five years. To magnify these returns even further, private equity firms also raise large amounts of debt to purchase these private companies — an investment strategy called Leveraged Buyout (LBO). LBOs are the main strategy of most private equity firms.

Much of the growth in equity happens from the time a startup is acquired by a private equity firm to the time the IPO is announced. The growth is unparalleled compared to the return on investment the company’s equity would make in the public equity market, thus robbing the average person whose only point of access to these companies would be through the public equity market. Once again, this is a way where high net-worth individuals grow their wealth through methods that average people would have no access to, deepening the wealth gap in our society.

FINDING A SOLUTION

A potential solution to decrease wealth inequality is to give more access for investment to smaller investors who want in. Recently, a way this has been brought into the market is through Special Purpose Acquisition Companies (SPACs). Also known as blank check companies, SPACs have been around for many years; however, they have been in the news a lot in 2020 due to their recent rise in popularity — SPACs raised over $20 billion in just 2020. Investors in SPACs can range from the public to private equity funds, giving access to higher returns on investment to the public. I will further explore SPACs in future articles.

CONCLUSION

In this piece we have discussed ways that already wealthy individuals and families have been able to have superior returns on assets compared to the average person, increasing wealth inequality in American society. Coupled with private wealth management and a team of lawyers, these already rich individuals and families find tax loopholes and other strategic ways of investment that the average American has no access to.

This article specifically focused on how shadow banking is done through private equity firms and hedge funds. I also looked at SPACs, a potential solution that has been used to break the barrier which stops the public from accessing these high-yield growth investments. However, not much else has come through policy initiatives to help include more of the public in the returns of hedge funds and private equity firms, other than access to the equity market through brokerages and trading websites like Robinhood. In the future, shadow banking regulations and entry requirements may become more of a concern to authorities as they continue to widen the wealth gap between the rich and poor in the United States.

REFERENCES

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