The Economist - USA (2020-09-05)

The EconomistSeptember 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.

irrs 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&p500 index in

America’s public stockmarkets. Recently

investors have developed measures

dubbed “public-market equivalents”

(pmes), which compare the results of

investing in private markets with public

ones. But pmes 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 irrs. 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.

Private equity’s dodgy data remain a huge headache

Still, the recent suspension happened

not because of methodological concerns,

but because of questions about data integ-

rity. Nine World Bank whistle-blowers

have alerted management to alleged “irreg-

ularities” in the indices published in 2017

and 2019, including for Azerbaijan, China,

Saudi Arabia and the United Arab Emirates.

It is not hard to see why countries might

want the figures to be fiddled. Falling down

the rankings is politically embarrassing.

The World Bank, meanwhile, may have an

incentive to keep relations with important

members sweet. In 2017 its leaders grew

concerned that China’s dbranking would

fall, which led the bank to double check the

results, an ex-insider says. After fixing a

coding error and tweaking a judgment call,

its ranking did not drop.

A further source of uneasiness comes

from countries paying the World Bank for

advice on how to rise up the dbrankings.

China, Saudi Arabia and the United Arab

Emirates all pay for such Reimbursable Ad-

visory Services (ras), which in the past

were delivered by some dbstaffers them-

selves. (The use of dbofficials in this way

was stopped in 2019.)

Some performance improvements defy

logic. An email seen by The Economistsug-

gests that Azerbaijan’s rise to attain the top

score globally for legal rights when obtain-

ing credit last year was particularly contro-

versial. Its overall score declined.

The World Bank is doing a thorough au-

dit of its processes, including those relat-

ing to the ras. Whatever the investigation

uncovers, the saga highlights the tension

between the institution’s different roles.

The Bank likes to think that its diplomatic

and research functions are complemen-

tary. If only things were so simple. 7