September 2015 Issue
Benchmarking in the private equity arena, as anyone tasked with overseeing the process can tell you, is an extremely challenging endeavour. One reason for this is that private equity is a relatively new asset class involving irregular timing of cash flows. Another is that private equity tends to rely on measures of returns that are not standard when compared to other asset classes.
Of course, the purpose of creating a benchmark in private equity is to establish a measure which can be used to evaluate the performance of an actively managed portfolio. According to analysis by the Chartered Alternative Investment Analyst Association – ‘Setting the Benchmark: Spotlight on Private Equity’ – a robust private equity benchmark should be transparent, unambiguous, frameable, customisable, investable and appropriate.
However, the difficulty is that new investors are often unclear or unaware about the differences between the common methods for measuring private equity performance, as well as how they compare with asset class returns elsewhere.
To establish what it is that should be delivered to the end investor, one must first recognise the key characteristics of private equity, as well appreciating that there is a fair degree of ambiguity surrounding the understanding of performance in this particular asset class.
Creating a benchmark
When creating a robust private equity benchmark, a number of properties must be included. According to Jesse Reyes, managing director of J-Curve Advisors LLC, there are four types of benchmarks available to private equity investors: (i) compare a fund or portfolio to the industry; (ii) compare a fund or portfolio to the public markets; (iii) compare the industry to the public markets; and (iv) compare a fund or portfolio to the public markets and compare that to how well the private equity industry did relative to the public markets.
“The calculation of returns and performance for private equity remains a complex endeavour.”
“Benchmarks range from the trivial – ‘What was the return last year?’ or ‘I want a 10 percent real return’ – to the extremely complicated – for example, a set of heuristics and algorithms that can be used to evaluate a complicated investment structure,” explains Mr Reyes. “The choice of a benchmark is actually quite complicated in that a true benchmark should be chosen not only on the basis of the investment decision being evaluated, but also on whether the benchmark is intended for direct comparison or, instead, for what we call an opportunity cost comparison.”
For Joe Steer, director of research at the British Private Equity & Venture Capital Association (BVCA), it is important for firms to know what it is they are benchmarking against. If benchmarked against listed equities, this would mean taking steps to compare like with like – such as using a public market equivalent calculation instead of comparing an internal rate of return (IRR) with a time-weighted return.
“When benchmarking against other private equity funds, an understanding of the investment strategies and vintages of peers is absolutely crucial,” suggests Mr Steer. “In addition, ensuring that any data set that is used for comparison – such as the BVCA’s Performance Measurement Survey – is as comprehensive as possible is equally important.”
Understanding performance
Due to the irregularity of cash flows, there is a definite need for an investor to be able to see the overall picture – not only to gauge the attributes of an investments performance, but also to reduce the ambiguity that exists in the benchmarking process.
“Multiples are an important part of the process,” notes Mr Steer. “Investments into private equity have differently timed and sized cash flows, so an IRR on its own may give a misleading picture of performance. A very small absolute return, for instance, can produce a high IRR if it is over a short time period. By looking at both IRRs and multiples, an investor is able to gain a balanced view of the overall performance of a fund.”
The holistic view
Balanced view or otherwise, it is appropriate to ask to what extent multiple measurements allow for a more holistic view of the success of a private equity investment portfolio. Pointedly, how can investors ensure that a balanced view of performance is captured that includes quantitative and qualitative measures over short and long term periods?
According to Mr Reyes, the investor should not rely on just one returns measure to evaluate performance of a private equity investment. “Other measures, such as realisation ratios and investment multiples, among others, help the investor to develop a more holistic view of an investment’s performance,” he says.
For Mr Steer, a combination of IRRs, which take account of multiple cash flows, and multiples, which show the size of a return, are better measurements. “These are well-established metrics which offer investors a holistic view of a fund’s performance,” he says.
Future benchmarking
While the process can sometimes have the appearance of being straightforward, the calculation of returns and performance for private equity remains a complex endeavour. “Private equity shares issues in methodological confusion with other asset classes such as real estate and other fixed life investment vehicles. The investor must take care that they understand what is being measured, how it is being measured and what is being used to benchmark returns,” says Mr Reyes.
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Fraser Tennant