Simon Scott: The Latest Horror: Equity Investments, May 2023
Updated: Oct 23
About this paper
In this May 2023 guest paper, Simon Scott examines proposals for counting equity investment as Official Development Assistance (ODA). He identifies five objections concerning grant equivalents, risk margins, caps on reported returns, comparability between reporting approaches and public disclosure.
The analysis responds to proposals issued on 19 May 2023 for a Working Party on Development Finance Statistics meeting starting on 30 May. It also compares them with the March 2023 draft and the framework agreed at the 2016 DAC High Level Meeting.
Editorial note: The full original paper follows. Simon Scott’s arguments, judgments and references to proposals are retained in their May 2023 historical context.
The latest horror: equity investment
by Simon Scott
The DAC’s latest proposals for scoring ODA on equity investment were issued on 19 May 2023, for approval by its Working Party on Development Finance Statistics at a meeting starting on 30 May.
They incorporate many changes from a version issued in March but both documents follow a playbook signed off at the 2016 DAC High Level Meeting, on which I have commented here.
The main problems with the proposals are:
1. Fundamental misunderstanding of grant equivalent methodology
2. Incorrect inclusion of risk margins in discount rates applied ex-post
3. Arbitrary, unstatistical capping of reporting on reflows
4. Built-in incomparability of numbers from the institutional vs. instrument approach
5. Unprecedented lack of transparency in data disclosure.
There are also other problems. The discount rates are nowhere justified, the workings of compound interest are misunderstood, and the methodology will not be applied consistently to all equity investments. But the five points above are crucial and disqualifying, so they merit some explanation.
1. Fundamental misunderstanding of grant equivalent methodology
This is the hardest problem to grasp but it is the core error in the proposal, so it must be tackled first.
Grant equivalents are the difference between a transaction’s outflows and reflows, with all flows first reduced to their value in a specified base year. Since all amounts entering the calculation are expressed in the “present value” of the base year, they only have meaning in that base year.
The ex-post method proposed in the paper (and already proposed in 2016) fails to recognise this. It first reports upfront the full nominal value invested. When reflows are received (dividends and final sale proceeds) it discounts them to their “present value” in the year the investment was made, yet it reports these amounts against the year of receipt (see Table 3 of the original document here).
This is a basic error. The present value of returns in the year they are received is just their nominal value. Discounting them to the value they had in an earlier year, but reporting them in the year they are received, is statistical nonsense.
It is equally nonsense to consider the grant equivalent of an investment as a fixed amount, invariable by year, so that ex-post calculations can lead to later arithmetical adjustments to ex-ante figures (Table 2 here). The ex-ante figure is only valid in the year of the investment. It has no meaning in any other year, and it cannot be just added to, or cut back, in any other year.
Oddly enough, the DAC recognised this in its debt relief rules. Flawed though those rules were in other ways, they at least recalculated the originally reported grant equivalent in the values of the year of debt treatment before subtracting it from the grant equivalent of the restructured loan to arrive at the grant equivalent of the treatment. It “us[ed] the date of treatment as time reference” for its ex-post calculation. The proposed equity methodology fails to do this, and is in error.
The latest version of the equity document omits the two tables cited above, perhaps to try to hide the fundamental error they reveal. Instead it suggests a far-fetched method based on adding together the ex-ante grant equivalents of multiple investments exited in the same year (page 9 here). But this makes the same error of treating ex-ante grant equivalents as fixed figures that are both valid and adjustable in any later year.
2. Incorrect inclusion of risk margins in discount rates applied ex-post
Financial risk applies only to the future. It is the chance that returns will be received; it is not the intrinsic value of those returns. When calculating the value of a past payment, one can only allow for the change in the value of money, not for risk. So, as William Hynes and I observed ten years ago, “An ex-post calculation would use a risk-free discount rate”.
The proposal does the opposite. It includes risk margins in discount rates it applies to known past payments. This is a conceptual error. Risk has been run, payments have been made or not made, and the record of them already embodies – or rather, entombs – the risk, which is now a dead issue.
3. Arbitrary, unstatistical capping of reporting on reflows
For no good reason, the proposal – again following the 2016 playbook – decrees that no equity investment can ever be recorded in ODA as having realised a profit in nominal terms. Even if total reflows exceed the amount invested by orders of magnitude, ODA will record that only the original nominal amount has been returned. This is deliberate mismeasurement; among other things, it will record the same amount for investments with very different returns.
4. Built-in incomparability of numbers from the institutional vs. instrument approach
The proposal declares that “comparability is a key feature of DAC statistics” and foreshadows discussions on how to monitor the comparability of ODA reporting of equity investment using the “instrument” and “institutional” approaches.
However, it will be impossible to reconcile these two figures. The three errors above will all exaggerate the donor effort recorded under the instrument approach, so that it will over the long term vastly exceed the real effort recorded in terms of net contributions to investing institutions.
5. Unprecedented lack of transparency in data disclosure
ODA is supposed to record taxpayers’ money going to development. The public has a right to know exactly how it is spent. But under the proposal, no information will be disclosed at the level of individual investments on expected returns, actual returns, current holdings, or expected maturity dates. This will make it impossible for taxpayers to know what is going on with investments, or even to check whether ODA amounts have been calculated according to the rules.
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It is a mystery to me how such bizarre and preposterous proposals could have come before an OECD committee for approval as statistical rules. Any self-respecting statistician must reject them, as they would produce figures that are not just wrong, but meaningless.
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