Can private equity’s numbers be trusted?
More transparency is needed as the industry attracts new investors
In “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 impressed by the itchy feel of Scottish fashion and his first pint of stout.
Running into cloud is a good description 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 Commission, America’s markets watchdog, broadened the pool of “accredited investors” 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 private—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 specify 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-crunchers, 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 money 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&P 500 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 industry, which attracts some of the world’s shrewdest investors, has yet to come up with a way to measure the riskiness 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 disturbingly 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 private-equity giant, retorted that his arguments were based on “flawed assumptions 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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