The Economist
September 5th 2020
Finance & economics
65
2
Buttonwood
Impaired visibility
I
n “the black island”
, Tintin, the
quiff-sporting boy reporter, uses a
plane to chase a pair of forgers flying over
Scotland. As he closes in on them, they
suddenly disappear into a bank of
clouds. “Just as I feared,” says his pilot.
“Running into cloud.” After crashing into
a dyke, Tintin emerges bruised but im-
pressed by the itchy feel of Scottish
fashion and his first pint of stout.
Running into cloud is a good descrip-
tion of the sustained rush into private
equity. Sophisticated investors—pension
funds, insurers and the like—have
poured money into the asset class in
recent years. Soon, in America at least,
they may have more company. On August
26th the Securities and Exchange Com-
mission, America’s markets watchdog,
broadened the pool of “accredited in-
vestors” deemed savvy enough to play in
private markets. They may include some
retail investors.
But veterans and novices alike face
the same visibility problem. Working out
how much money is channelled into
private equity, how much it makes and
whether the adventure is worth it is
fiendishly tricky. That is because, even if
private equity today is not all that priv-
ate—its biggest firms are listed, and they
routinely buy and sell companies and
securities in public markets—the data
leave a lot to be desired.
Three areas of fuzziness stand out.
First is the amount of money allocated to
the industry. Some pension funds speci-
fy the proportion of their assets that they
intend to invest in private equity but few
reveal their precise disbursements.
Reports by third-party researchers that
calculate aggregate fundraising are
“directionally suggestive” at best, says
one. He confesses their estimates often
prove wrong six months on, sometimes
by as much as 25%. Between data-crunch-
ers, discrepancies arise. Pitchbook, one of
them, says private-equity funds raised
$474bn globally last year; Preqin, another,
reckons they collected $595bn.
Assessing the returns the industry
generates is the next headache. Investors
commit money to private-equity funds.
They provide it when it is called upon to
buy assets. The favourite performance
indicator of such funds is the “internal rate
of return” (
irr
), which calculates returns
on the capital deployed to buy the assets,
but ignores the rest of the committed
money. For investors, immobilising mon-
ey carries an opportunity cost, all the more
so in an environment where idle cash, in
real terms, earns you nothing or worse.
irr
s can be easily manipulated by altering
the timing of payments and by using
leverage. They also assume that when
private-equity firms return capital to
investors, it can be reinvested at the same
rate that the rest of the fund is earning.
That is hardly guaranteed.
The third shortcoming is the industry’s
lack of a widely accepted benchmark—the
equivalent, say, of the
s
&
p
500 index in
America’s public stockmarkets. Recently
investors have developed measures
dubbed “public-market equivalents”
(
pme
s),
which compare the results of
investing in private markets with public
ones. But
pme
s often resemble fiddly
do-it-yourself accounting devices rather
than something dependable. The in-
dustry, which attracts some of the
world’s shrewdest investors, has yet to
come up with a way to measure the risk-
iness of an investment. Public markets
have had the Sharpe ratio, which is used
to gauge the risk-adjusted return of
assets, for over 50 years.
The industry continues to attract
newcomers who buy into its claims that
it is a profitable form of investment and a
good way to diversify. It insists that
investors who stay in for the long haul
have enjoyed buoyant returns. But the
flimsiness of the data makes it disturb-
ingly hard to verify these claims and
means the critics of the industry and its
defenders rarely fight on common
ground. Ludovic Phalippou, an Oxford
University academic, claimed in July that
the numbers were “a myth perpetuated
by thousands of clever people”, mainly
because of misuse of
irr
s.
kkr
, a priv-
ate-equity giant, retorted that his argu-
ments were based on “flawed assump-
tions and selective engagement with the
facts”. Because of the deficiencies in the
data, it was hard to say whose claims
carried more weight.
Mysteriousness has long added to
private equity’s elite status. But the more
money the industry raises and prepares
to deploy and the more it is open to
ordinary investors, the more pressure it
will come under from regulators to
improve transparency. It doesn’t take a
Tintin to work that out.
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