London Business School Coller Institute of Private Equity

SO MUCH FOR SOPHISTICATION - MISTAKES BY 'SOPHISTICATED INVESTORS' SUGGEST TO PETER MORRIS THAT THE ORGANISATION OF MARKETS IS FLAWED.

24 October 2011

Last year I wrote a report about private equity for the CSFI  entitled Private Equity, Public Loss? It drew on  academic research to suggest that, although private equity (meaning leveraged buyouts, not venture capital) may be good for the economy, it does not appear to be good for investors as a group. That is because the private equity managers extract in fees most or all of the extra returns that they generate. On average, their investors are left with extra risk and illiquidity.

Private equity managers’ lobby groups naturally issued rebuttals. More independent observers, such as the Financial Times and The Economist, gave it favourable coverage. By the time I had finished writing it, though, I realised that private equity itself is less important than what it reveals about a much bigger problem. It perfectly illustrates a serious flaw in the way policy-makers think about the world and organise financial markets.

This is the concept of the so-called “sophisticated investor”. More and more evidence is emerging that sophisticated investors are collectively getting their “alternative invest- ments” wrong. This has important public consequences and policy-makers need to adjust their thinking to reflect it. Most of all, disclosure needs to improve.

First, what is a “sophisticated investor”?

Financial regulators put investors into one of two broad categories: retail and sophis- ticated. Crudely, these translate into small and big. Most individuals are retail investors. Regulators protect them by restricting what they can buy. They take the view that buying a comp- licated financial product is trickier than buying, say, a washing machine.

Regulators believe bigger investors are immune to such “information asymmetries”. Because they can look after themselves, policy-makers think it is safe to let them buy complex investments in the same way retail consumers buy washing machines – that is, freely.

“Sophisticated” is a generic term for these bigger investors. The technical terms vary: the US uses “accredited”, the UK, “qualified”. But the basic idea is the same. Sophisticated investors generally include banks, insurance companies, pension plans, charitable endowments, and individuals with a minimum level of financial resources.

The existing policy framework goes further, though. It is not just considered safe to let sophisticated investors buy what they want – it is highly desirable. Think back to washing machines. The assumption is that well informed, rational consumers will drive producers to make optimal appliances. The world of kitchen chores will become a better place.  

It is an article of faith for most economists that the same thing applies to big investors. Just as self-interested consumers will lead to better washing machines, sophisticated investors will make optimal investments. That means they will automatically (as a group) invest their capital where it is most productive. Result: the world will become a more efficient (wealthier) place. Unfortunately, the real world often fails to live up to the  assumptions of economists. On 23 October 2008, Alan Greenspan told the US Congress: “Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief.”

Banks are the most dramatic proof that sophisticated investors do not always do the right thing. But it should hardly be a surprise to discover that they are not alone. Banks are the ultimate “sophisticated investors”. If they can collectively get it so wrong, why would anyone assume prima facie that others on average get it right?

In one area, evidence increasingly suggests they do not – as a group – get it right: that is, with “alternative” investments.

“Alternative” in this context has no clear or consistent definition. It implies that the investment in question will behave differently from old-fashioned asset classes such as bonds or shares. That will diversify a portfolio – catnip for any investor. In practice, “alternative investments” mainly comprise commodities, hedge funds and private equity. Over the past 30 years, the trend has been for big investors to put more of their eggs in these baskets.

But it looks increasingly as though these investments on average are very profitable for the people who run them  but not for the owners of the capital invested. In the case of retail investors, this situation is only too familiar. That is one reason why regulators give them some protection.

In February 2011, the World Economic Forum published a report called The Future of Long-term Investing. Its academic research was overseen by Josh Lerner, a Harvard Business School professor who is one of the best known experts on private equity. In discussing private equity, the WEF report says: “The conclusion from these and related studies is that general partners are skilled enough in deal selection to generate attractive gross returns. However, due to a variety of factors, the industry has been organised so that most of the rents (profits) from these skills go to the fund managers themselves, rather than to the [investors].” Another leading private equity academic, Per Stromberg, wrote in June 2011: “The only thing we do not see as bright about PE is the return it is giving back to its [investors].”

Hedge funds – the best known form of “alternative investment” – have received even more capital from sophisticated investors than private equity. Yet the picture looks similar for hedge funds as for private equity. John Wiley will publish a book later this year called The Hedge Fund Mirage. Its author, Simon Lack, writes bluntly: “All the money that’s ever been invested in hedge funds should instead have been put in Treasury bills.” Academic research has come to similar conclusions.

It is increasingly clear that the blind faith economists and policy-makers place in large investors is (in aggregate) misplaced. Assuming that these investors need no oversight has just made it easier for various intermediaries to take advantage of them. The intermediaries themselves give the game away. In 2007, Damon Buffini of Permira (one of the world’s leading private equity managers) told the UK Parliament’s Treasury Select Committee: “Our pension funds [i.e. investors] are some of the largest and most sophis- ticated in the world...”. In 2010, Goldman Sachs’s Fabrice Tourre told the US Senate Permanent Investigations Committee: “I wish to repeat – I did not mislead IKB or ACA, two of the most sophisticated institutional investors in these products anywhere in the world.” IKB, of course, is a German bank that had to be bailed out after losing money on structured credit investments.

It is crucial to realise that the people who work for sophisticated investors are neither necessarily foolish nor acting in bad faith. Economists are always the first to point out that incentives matter. People who work for sophisticated investors may be behaving perfectly rationally. But if their incentives are wrong, the result will be sub-optimal for society.

Aligning different people’s interests is hard. Think of the conflicts of interest between a quoted company’s managers and its shareholders. Economists call this a principal/agent problem.

But principal/agent problems are not limited to quoted companies. They exist everywhere, including at big investors. The head of alternative investments at a large pension fund will probably benefit if it allocates more to alternative investments. So will the consultants who advise the fund to do so (more complexity is always more profitable for them). The decision may not be in the interests of the fund’s actual stakeholders: scheme members, corporate sponsors or taxpayers.

Nor does any of this provide a reason to dismiss alternative investments per se. Some managers of these investments certainly have real skill. Some investors already receive positive net returns from buying them. More appropriate fee structures would let more investors do so. But it would be equally silly to criticise managers for charging excessive fees. They are simply charging, quite legally, what the market will bear.

The problem is that this market is failing. What, then, should be done?

Policy-makers must start by changing their world view. They must accept that principal/ agent problems affect all sophisticated investors – not just banks. This may be why sophisticated investors have been (in aggregate) making sub-optimal alternative investments. Collectively, these investors control the vast majority of the world’s wealth. What they choose to do with their cash is the main driver of financial markets. Assuming blindly that they will do the right thing is dangerous.

A traditional next step would be to call for more regulation. But if this amounts to bureaucrats telling investors what to do, it is likely to be expensive and ineffective and to have unintended consequences.

A more effective approach would be to use regulation to harness people’s self-interest. In the case of sophisticated investors, regulators must make it possible for principals to hold agents accountable. This in turn means improving disclosure. Principals must have access to data that allows them to evaluate the performance of their agents: both pension fund managers and the investment managers they hire. In effect, rather than telling investors what to do, regulators should tell them to report in detail on what they have done.

On the face of it, this might seem ludicrous. Even with all the information in the world, an average pension scheme member or taxpayer would never have the skills to evaluate a pension fund manager’s performance. That is irrelevant. No one thinks the stock market works because the average individual investor has the time or skills to value companies. If regulators made sophisticated investors disclose meaningful data, self-interest would rapidly bring the right expertise to bear. The “sophisticated investment” market would become more efficient. Individual investments and managers could be assessed for the first time by experts without a vested interest. 

Agents find this kind of transparency very threatening. Traditional, prescriptive regulation may be annoying and expensive, but it creates a barrier to entry that ends up protecting incumbents. Transparency is more dangerous for them. One of the main ways agents resist transparency is by citing competitive advantage and proprietary expertise. The implication is that disclosing what they do would be the equivalent of forcing Coca Cola to publish its secret formula. In the case of private equity, this is simply untrue. It may carry more weight in other cases.

Until now, policy-makers have generally given in to demands for privacy. Since they thought they could count on sophisticated investors to do the right thing, this made sense. Even if it was all done behind closed doors, they could be sure that investors were allocating capital in an optimal way.  It looks as though that assumption is invalid. Policy-makers, therefore, need to re-think their approach. They ought to conclude that the public interest trumps the private interest of a few agents. They should aim some sunlight at the “sophisticated investment” market.
Peter Morris worked in financial services for 25 years and is the author of the CSFI report Private Equity, Public Loss?

This article first appeared in the October 2011 edition of “Financial World”

©ifs School of Finance’

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