New methods for comparing private equity returns are gaining favor
This analysis originally appeared in the Bloomberg Brief Private Equity Newsletter.
Comparing private equity returns to public market investments in a meaningful way is no easy task. The most common technique — to put the net internal rate of return on the private market investments up against a public stock index — can create anomalous and misleading results. IRRs are based on the pacing of cash flows while stock indexes measure gains in asset values over time, so financial analysts will tell you it’s comparing apples and oranges.
Increasingly, limited partners are using public market-equivalent (PME) benchmarks to evaluate past investments and make decisions, and general partners are using them to sell their products. PMEs are more complex to calculate but are on better methodological footing.
“It was a much better way of benchmarking a single fund’s return than using a straight index-time-weighted return,” Hamilton Lane Vice President of Research Griff Norville said in a telephone interview. “If you are going to benchmark a fund against an index, it’s not really fair. The fund takes a while to put capital to work, it distributes capital over a long period of time, it might have a big tail on the end of it.”
“The open question is, where do you start the index and where do you end it? You are also not giving the GP proper credit for the timing and size of the cash flows,” he said.
New PME benchmarks have been developed over the past decade to allow investors to better assess the relative merits of different asset classes.
Despite the increasing sophistication of PME methodologies, many investors still use their own techniques to measure performance, often based on comparing IRRs to stock indexes.
For instance, the primary policy benchmark for Oregon Investment Council, like many other public investors, is the Russell 3000 index plus 3 percent. The council uses IRR and multiple benchmarks to compare to peer funds within the same private equity investment category, spokesman Michael Cox said in an e-mail.
The Florida Retirement System, managed by the Florida State Board of Administration, uses two benchmarks. The primary benchmark, used for longer-term performance, is the MSCI All Country World Investable Market Index — in dollar terms, net of withholding taxes on non-resident institutional investors, adjusted to reflect the provisions of the Protecting Florida’s Investments Act — plus a 300 basis point annual premium, spokesman John Kuczwanski said in an e-mail.
“The primary benchmark measures the opportunity cost and risk of investing in private equity. The opportunity cost of investing in public equity versus private equity plus a risk premium of 300 basis points,” Kuczwanski said.” The risk premium reflects private equity’s illiquidity, leverage and idiosyncratic risks.” A secondary benchmark is based on “a large universe of private equity funds.”
Employees Retirement System of Texas compares private equity performance to the S&P 1500 and uses two private equity benchmarks, along with absolute measure it developed, Private Equity Director Wesley Gipson said in an e-mail. It also uses IRR and investment multiples to measure performance.
While PMEs are useful in evaluating both single funds and whole portfolios, time-weighted returns such as IRRs are a valid way of measuring whole portfolios, said Hamilton Lane’s Norville.
“Calculating a time-weighted return is fairly straight forward, and complexity is not always your friend. For CIOs and the boards of these pension plans, keeping things simple and still meaningful is a good quality in a benchmark,” he said. “That’s different than doing a fund-by-fund benchmark. That’s where PME is much more applicable.”
“For a single fund, capital ramps up over the investment period and then ramps down. If you have a portfolio that’s not changing in terms of capital at work over time, a time-weighted return is a perfectly acceptable method of benchmarking that portfolio. The IRR is not going to be that different. The benchmark is not going to be that much different,” he said.
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