Coming up with economic policy is a difficult, unforgiving task. To make the best of it, it helps to work with an accurate model of how the economy works. If you use a misleading model and act on it, you can’t reasonably expect good outcomes: in that scenario, we end up, as JM Keynes warned in the 1930s, with “madmen in authority”, acting according to the precepts of “some defunct economist”.
But that’s exactly where we are. One of the most deeply held and frequently heard propositions about capitalism is that it revolves around private companies and individuals taking risks. When, earlier this year, the US government arranged a rescue package for Silicon Valley Bank, for instance, among the many objections to it was the claim that the rescue contravened capitalism’s risk norms.
“The US is supposed to be a capitalist economy,” said the billionaire Ken Griffin, founder of the US investment firm Citadel, “and that’s breaking down before our eyes.” Capitalism, Griffin argued, is about taking risk. If returns are achievable without taking risk – the apparent message of the bailout – then, for Griffin at least, it is no longer capitalism.
This view of the world directly informs wide swaths of economic policymaking today. When business confidence ebbs and investment declines, an increasingly common policy response is to “de-risk” business investment – usually by subsidising it or guaranteeing returns. The prime example in recent memory was the US’s Inflation Reduction Act of 2022, the kernel of which is a package of tax credits designed to make private investment in clean energy less risky.
But examine the economy, and it becomes clear: capitalism has become less and less about corporate risk-taking in recent decades. To be sure, many businesses do take significant risks. The independent small business owner who opens a new cafe in London generally faces intense competition and massive risk. But as political scientist Jacob Hacker has argued, business in general has been enormously skilled in recent times at offloading risk – principally by dumping it on those least able to bear it: ordinary households.
Paradoxically, the best example of a business usually regarded as being fundamentally about risk-taking but which in fact is not, is Ken Griffin’s own: alternative asset management, an umbrella term for hedge funds, private equity and the like. (“Alternative” here means anything other than publicly listed stocks and bonds.) Asset managers are anything but marginal, exotic firms – they manage more than $100tn of clients’ money globally and control everything from Center Parcs UK to your local Morrisons.
But let’s look at what asset management companies in places like Britain and the US actually do. Three considerations are paramount.
First, there is the matter of whose capital is put at risk when alternative asset managers such as Citadel, Blackstone and KKR invest. In large part, it’s not theirs. The proportion of equity invested by a typical hedge or private equity fund that is the asset manager’s own is usually between 1% and 3%. The rest is that of their external investor clients (the “limited partners”), which include pension schemes.
Second, consider how an asset manager’s investments are designed. For one thing, its own financial participation in, and management of, its investment funds is usually through a vehicle (the “general partnership”) that is constituted as a separate entity, precisely in order to insulate the firm and its professionals from liability risk.
Furthermore, the fund and its manager is generally distanced from underlying investments by a chain of intermediary holding companies that protect it from the risk inherent in those investments. In leveraged buyouts, where money is borrowed to help finance a deal, the debt goes on to the balance sheet of the company the fund has acquired. This means if trouble arises in repaying the debt, it is not the investment fund that is on the hook, still less its manager.
Third and last, fee structures also distance asset managers from risk. If a fund underperforms, they may earn no performance fee (based on fund profits), but they do have the considerable consolation – a form of risk insurance, if you like – of the guaranteed management fee, usually representing about 2% of limited partners’ committed capital, year after year. Essentially, management fees pay asset managers’ base salaries; performance fees pay bonuses.
In short, then, it would be far-fetched to suggest that what hedge funds and the like do amounts substantially to risk-taking. The only meaningful risk they themselves face is that of losing custom if fund returns prove underwhelming.
In reality, the business of alternative asset management is less about taking on risk than, in Hacker’s terms, moving it elsewhere. So when things go wrong, others bear the brunt. This can be the employees on the shopfloor of a retailer owned by private equity who find that they’ve shouldered the risk when they’re told they’re being laid off. It can be ordinary retirement savers, who find they have a meagre pension because the alternative funds in which their savings were invested by the asset manager have tanked.
Why does this matter? Because unless elected policymakers understand how risk is produced and distributed in modern economies, they will not be in a position to act appropriately and proportionately. That is why vague talk from politicians of being “pro-business” or “entrepreneurship” mean so little; the point is to learn from economic realities as they actually are, as opposed to how economics textbooks say they could or should be.
There is one very obvious policy recommendation for alternative asset management that flows from our understanding what they actually do with “risk”: taxing them more.
The main performance fee earned by alternative asset managers is “carried interest” – effectively, a profit share. In the UK and US, most asset management firms pay tax on this revenue at the capital gains rate, rather than the usually higher income tax rate. This is because the asset manager has typically been understood to be “taking on the entrepreneurial risk of the [investment]” – a standard justification for taxation as capital gain.
But as we have seen, this simply does not hold water. In 2017, the New York Times called the beneficial tax treatment of carried interest “a tax loophole for the rich that just won’t die”. It’s time to close it. In fact, the recent confirmation by Keir Starmer’s Labour party that it would do exactly that if it wins power was one of the few genuinely progressive and sensible economic policy moves it has made while in opposition.
Brett Christophers is a professor in the Institute for Housing and Urban Research at Sweden’s Uppsala University and author of Our Lives in Their Portfolios: Why Asset Managers Own the World
