World wealth is based on a paper-thin illusion



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The world is now richer than it was ever before, but only on paper. A large part of this prosperity can turn out to be apparent, as the global shift towards less liquid investments undermines the basis of valuation.

Private capital, infrastructure and private loans have become a major share of investment portfolios, which makes market values ​​more and more uncertain. The standard method of valuation of funds assumes that prices are available and that there is adequate trading liquidity for sales at these levels. This can apply to traditional investments, such as stocks and bonds. However, assets, such as private equity, are rarely traded or not traded at all, and therefore models or authorizations should instead be used.

Even for publicly traded assets, market values ​​can be less reliable than in the past. In recent years, the volume of trading in most asset classes has declined due to a reduction in the number of traders, regulations that make it more expensive to trade stocks, and central bank intervention. Meanwhile, prices for smaller shares, as well as numerous corporate and structured bonds, securities on the emerging market and the frontier market, and difficulties in terms of burdens may not be consistently available. These factors, in connection with the growth of large funds and the size of economies, mean that the possibility of selling at market prices is questionable.

Model-based evaluations are not surprisingly sensitive to the assumptions about key inputs that may not be easily verifiable. For example, the value of a private loan can be very sensitive to the alleged default rates and the correlation between defaults. For private equity and infrastructure, these models are based on the discounting of future cash flows. These can be distorted due to low rates and lower risk premiums. Models typically require the asset to be attributed to the asset at the end of the selected projection period. Changes in the assumptions about the cancellation value can have a significant impact on the results of models, in particular at the abnormally low interest rates prevailing from the global financial crisis, as a result of the central bank's efforts to maintain asset prices and increase spending with the effect of wealth.

Sometimes, known sales are used as brokers to establish or calibrate the value of the model. These problems have small sample sizes and a lack of accurate matching with the value being evaluated. Adjustments are necessarily subjective. Authorizations are sometimes based on sales between funds that are interconnected. This increases the risk of manipulation or error.

All valuations at market prices presuppose that the investor or fund can sell the fixed asset. Operators have considerable discretion and, as in 2008, they can introduce provisions on the "passage" in order to prevent the withdrawal of assets. In a major downturn or under unstable conditions, investors in funds with private assets are likely to face redemption limits if managers can not liquidate holdings. Under such conditions, market value will not be feasible. It can change during a sales decision and receipt of revenue. Where investments abroad, it is no longer possible to assume the possibility of returning funds in a period when globalization and the free movement of capital are at stake.

In addition to misrepresentation of wealth, problems of evaluation are generated by a number of systemic issues. First, market values ​​are asymmetric. Unrealized gains that do not generate money require borrowing against an investment to finance spending. This was a factor in the rising debt. If the value of the market value decreases, the property is reduced, but the loan still needs to be repaid. If the value of the assets provides loans, unrealized losses can trigger margin calls, create liquidity pressure and forced sales, which further lower prices.

Secondly, the incentive structures are distorted. Benefit-based compensation promotes aggressive evaluations that increase asset management and generate higher commissions for managers. This may not be fraudulent, as there is ambiguity about the value of non-marketable assets. As evidenced by history, independent audits and assurance procedures are not a guarantee for accurate estimates.

Thirdly, if the funds are incorrectly valued, the managers and fund managers may mislead the outgoing and entry prices. This creates potential transfers of wealth among investors. If the values ​​of the fund are overestimated, sell investors on the account of new ones; and vice versa, when they are underestimated.

The real value lies in the ability to convert your investments into cash. Marketing issues, especially private investment funds, are another unknown modern markets and finances. Risks are often not disclosed until it is too late.

Unfortunately, as investors can discover in the next recession, one way of using the financial crisis is to disclose what the financiers have ignored, deliberately or unintentionally, and what they did not find responsible for the control.

© 2019 Bloomberg L.P.

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