The EU's Next Target: Hedge Funds

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Hard on London?

If financial institutions in Europe start heading for the door, it will be London—the Continent's financial capital—that will be worst hit. Currently, more than four-fifths of European alternative investment players are based in the British capital, which fears billions of dollars of capital could be lost if Brussels' reforms are approved.

In response, the British government has proposed its own somewhat watered-down plan to manage the country's largest hedge funds and private equity firms through a beefed-up Financial Services Authority, the country's financial watchdog. But few expect these plans to gain traction compared with those already outlined by the European Commission. "Attention [over policy] has shifted to Brussels," says Rym Ayadi, senior research fellow at the Centre for European Policy Studies, a Brussels-based think tank.

Some also doubt whether the new rules are still needed, given the industry's sharp downturn. The economic slump and a contraction in bank lending already have reduced the number of leveraged buyouts—a major activity of private equity firms—by 60% in the first half of 2009, compared with the same period last year, according to data provider Dealogic (DL.L). The value of deals has similarly fallen 90%, to $6.8 billion, over the same period. With economic conditions continuing to squeeze the industry, some say adding yet more regulation might only make matters worse. "The market will be much more effective at sorting things out than policymakers in Brussels," sniffs a London-based financial lawyer who works for private equity firms but declines to be named.

"Much at Stake"

The bigger danger is that despite the shortcomings of private equity and hedge funds, driving them away could harm Europe's long-term growth. Their business models rely on identifying underperforming businesses (and other assets) and wringing value out of them—an essential tool for improving efficiency and creating wealth.

Going after the Masters of the Universe may help EU politicians win votes, but overzealous reform could put Europe at a global disadvantage if money moves instead to more hospitable locales. Says the AIMA's Baker: "Brussels shouldn't muck around with international capital flows. There's too much at stake."

Scott is a reporter in BusinessWeek's London bureau .

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