What gets into academics when they title their work? Private equity’s diversification illusion – economic co-movement and fair value reporting hardly seems calculated to set pulses racing – or people reading – yet it revolves around a point the value perspective feels to be well worth bringing to your attention.
In the paper, Kyle Welch of Harvard Business School addresses evidence that suggests that, until relatively recently; private equity investors were lulled into a false sense of security. Interestingly, this did not stem from any kind of analysis of what private equity investing actually entails but from a change in the way the asset class’s accounts are presented.
Recent changes in international accounting standards mean that best practice in private equity financial reporting no longer involves anchoring fair-value estimates to historical costs but by marking investments to market – that is to say, accounting for the fair value of an asset or liability based on its current market price.
This move had been broadly opposed by the private equity industry since clearly it was in its interests to present itself as a lower-risk and diversifying proposition for investors – and marking portfolios to market would make the sector look more volatile. What Welch investigates in his paper is what this accounting switch has meant for the beta of private equity investments.
The paper includes the following chart, which shows the three-year correlation of European private equity firms’ returns with the MSCI world index – both before and after the adoption of fair-value accounting. As you can see, this correlation was around zero before the switch but, afterwards, it progressed pretty quickly up towards 0.5.
Source: Private equity’s diversification illusion – economic co-movement and fair value reporting as at 14 January 2014.
Past performance is not a guide to future performance and may not be repeated.
Now, while this may look like a fairly gradual increase, the gentle slope is a result of the smoothing effect of the 12-month rolling data used. In reality, the change in private equity’s beta and correlation happened almost instantly after the adoption of fair-value accounting – at which point the sector lost a huge amount of it diversification appeal.
This makes intuitive sense, as the returns that are reported by the firms previously ignored listed equity market movements – and presumably they started looking at listed peers when valuing their positions. As private equity firms infrequently sell their investments, they have to make quarterly guesses about how much their investee companies have appreciated or depreciated.
What this also means of course is that, by not marking to market, private equity investors had for years effectively ignored – or perhaps been unaware of – the real volatility within their portfolios. Welch uses an observation by David Swensen, chief investment officer of Yale University’s endowment fund, to describe the possible impact of accounting information on investors’ asset allocation decisions.
“If two otherwise identical companies differ only in the form of organisation – one private, the other public – the infrequently and less aggressively valued private company appears much more stable than the frequently valued publicly traded company – particularly in a world where securities markets exhibit excess volatility,” says Swensen.
“Even though both companies react in identical fashion to the fundamental drivers of corporate value, the less volatile private equity boasts superior risk characteristics based solely on this measurement of the company’s true underlying volatility.” In other words, the nature of reporting and accounting leads to what welch calls a “diversification illusion for institutional investors”.
Now, the point of this article is not to criticise private equity investors – ok, the point of this article is not solely to criticise private equity investors. After all, it is shocking that the asset class’s diversification benefit actually stemmed from their not marking their assets to market.
We would however suggest there are some larger lessons here, the first being it is an error to rely on price volatility as your sole indicator of risk – the risk of a business stems from its underlying operations and how they are funded, not how from how the assets are priced. Furthermore, ignoring prices can actually be the right thing to do.
The idea certainly appears to have worked well enough for private equity – before investors started getting worked up about mark-to-market pricing on a continuing basis, the sector appeared low-risk and thus was able to find stable sources of funding, invest it in businesses and thereby add value. Might investors therefore do better to approach things from the other direction?
Rather than encouraging people to view private equity investments as being as volatile as public equity ones, we would instead argue that, if you are making an investment in any business – private or public – you should not automatically mark any gains or losses from the market straight across to your own investment portfolio. Instead, ignore the price of a business on the screen and look to mark its value prudently by assessing its operations on a multi-year timeframe.