Dispersing the ‘Diversification Illusion’ of Private Equity

(January 15, 2014) — Pre-crisis accounting measures have masked the correlation between public and private equity returns, and led investors to believe they are getting better returns than they really are, a new paper has found.

Kyle Welch, a former member of Stanford’s endowment team now a doctoral candidate at Harvard Business School, said changes in international accounting standards had laid bare just how closely related public and private equity returns are—and what these new measures mean for private equity funds.

Welch said that despite research to the contrary, “those marketing private equity assets continue to emphasize its diversification value, and demand for private equity investments has surged”.

Private equity assets sit at around $3 trillion worldwide, according to Preqin, and have grown steadily since the onset of the financial crisis.

Investors have been led to believe that the assets held in private equity funds would diversify the risk and return of their portfolios, but Welch claimed it was possible to see how this was widely untrue.

“Exploiting the change in international accounting, I show that returns provided by private equity firms understate the economic movement between private equity and market returns, creating a diversification illusion,” the paper said. “I find that private equity funds that adopted re-defined fair value accounting reported returns with increased market beta and correlations. Additionally, I find that abnormal returns to private equity firms disappear after adopting fair value standards.”

The new accounting methods that have been adopted are FAS 157 in the US and IAS 39 internationally. Under prior methods, a number of assumptions made allowances for illiquidity and conservative reporting. New standards assumed transactions of assets between willing parties, and restricted the previous methods of using historical costs as a measure of fair value.

Welch’s calculations found firms implementing updated fair value standards reported twice the market beta—and all alpha disappeared.

“Not only do assets move more closely to the market than previously reported but managers also benefited from transferring beta returns to alpha returns.”

He then cited Yale Endowment’s David Swensen to support his hypothesis on the lack of diversification and investor willingness to commit capital.

On this last point, however, it is the private equity funds themselves that stand to lose out by adopting the new accounting measures, Welch claimed.

“Firms implementing fair value standards exhibited a lower propensity to raise capital, raised less capital overall, raised less capital for each day they were in the market and raised less capital per investor,” the paper said.

These companies also spend more time soliciting new investments and bring in around 50% less capital than their counterparts.

To read the entire paper, click here.

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