Thursday, January 16, 2014

Refuting Private Equity’s Claims

Refuting Private Equity’s Claims

Yesterday I ran across an important piece of research that provides great insight into the role of private equity in endowment and pension portfolios.  Kyle Welchy is a Ph.D. candidate at Harvard Business School[1] who has been analyzing private equity’s claim that it adds value and diversifies investment portfolios.  Any manager who could satisfy both claims would be hugely valuable to any investor.  Wouldn’t you want superior returns, while lowering risk? Mr. Welchy’s paper, “Private Equity's Diversification Illusion: Economic Co-movement and Fair Value Reporting (January 14, 2014)” dispels this claim.[2]
Client Service (1997)

Traditionally money managers have used historic returns for private equity and market data for the S&P 500 or another public market index to show that their asset class has a low correlation to public stocks (diminished risk) and consistently generates alpha (better returns than the stock market).  However, the historic returns for private equity were badly distorted by accounting standards, and thus it’s not surprising that the apparent correlation between PE and stocks was low.  As Mr. Welchy discusses, traditional accounting standards encouraged money managers to keep investments at cost until a significant event required a revaluation.  So even though the equity value of a PE investment was really rising or following in economic terms, accounting left the value of the investment’s value unchanged, which led to the illusion of lower risk.

Several years ago, the accounting profession recognized that PE investments needed to be valued more frequently and with an eye to approximating economic value.[3]  In Europe the new standard has been in place long enough, so Mr. Welchy had enough data to test PE’s claim that it adds value and reduces risk.  When the accounting methods improved, PE’s advantage disappeared, according to Mr. Welchy’s paper.

As CIO for North Carolina and then in this blog, I’ve argued endlessly that private equity is nothing more than illiquid leveraged equity.   Common sense always suggested that there was nothing magic about private equity.  Shouldn’t a public and private company in the same in the same industry face virtually identical risks?  Is there any reason to believe that private equity managers are systematically smarter than any other group of money managers?  Unfortunately, there was very little good data to refute the industry’s claims.  I simply chose to ignore their arguments.  Thanks to Mr. Welchy we now have a bit of data.

Interestingly, Mr. Welchy’s work also shows that PE fundraising in Europe diminished after the accounting standard changed, as investors got a clearer picture of PE’s investment performance.  I hope this conclusion turns out to be correct.  As the years go by, I expect researchers will replicate Mr. Welchy’s research with US data, and look at longer-term results, so we get further tests of private equity’s claims.

I urge my former colleagues at pensions and endowments to read Mr. Welchy’s study.

[3] International Accounting Standard 39|Financial Instruments: Recognition and Measurement (IAS 39) and Statement of Financial Accounting Standards No. 157|Fair Value Measurements (FAS 157)

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