How to benchmark performance when assets are private
As private market assets become larger and more important allocations in pension plan portfolios, the methods for effectively benchmarking performance will become more relevant to the institutional investment community, according to a recent report by Callan.
While several methods exist to measure manager and asset performance, it can be difficult for investors to get their hands on robust data, as private partnerships tend to be far less transparent than their public counterparts.
The report analyzed the evaluation process for private equity asset classes in two contexts: how the asset class impacts the value at the total plan level relative to a policy benchmark; and how the asset class and constituent managers perform at the asset class level compared to asset class specific measures.
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It highlighted the vintage year concept, which suggests that to compare the performance of private partnerships, they must be similar in age. “Evaluating a three-year-old partnership against one that is eight would be akin to comparing a second-grader to a high schooler — the development stage and capabilities will be markedly different,” noted the report.
Further, it said benchmarking methodologies and return calculations differ from public securities. A time-weighted return calculation is most suitable for assessing public market managers, because it demonstrates the manager’s performance regardless of the inflow or outflow of capital throughout a specific duration.
However, for certain private asset managers, measuring the internal rate of return may be more useful. The report noted these calculations don’t smooth out the changes that occur when capital is added; instead, they’re dollar-weighted and take additional cash inflows into account by recalculating the return results going back to the investment’s infancy.
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These calculations are extremely sensitive to cash flows at the beginning of their calculation periods, said the report. “Large early cash outflows can permanently skew returns in an outsized positive manner. . . . Conversely, as the IRR calculation timeframe extends, the calculation becomes static, varying little even with meaningful cash flow or valuation changes.”
These effects can’t be detected by looking at the IRR on a stand-alone basis, the report noted. “All percentage return calculations can help estimate economic value creation, but each has drawbacks and should not be held as sacrosanct.”
To assess returns, the report highlighted three performance ratios used by the private equity industry. Distributions divided by paid-in capital measures an asset’s liquidity by how much has been distributed back to investors in total to date compared with how much they’ve invested.
Residual value divided by paid-in capital measures how much unrealized value remains in the investment, and total value divided by paid-in capital measures the total gain so far.
As the purpose of private equity investment is to secure large dollar gains over time, the report noted it’s preferable to use total value divided by paid-in capital for evaluating partnership performance. With that, it said, the underlying economics of investments are more evident than with percentage returns.
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While all of these calculations shed some light on private asset performance, it can be problematic to get the data to make the calculations in the first place, according to the report. “A key challenge in benchmarking private equity is that partnership performance data are not generally made available by general partners to non-investors.”
In addition, general partners hold their limited partners to non-disclosure agreements, to the degree they can by law. The report noted this information is made available solely by database providers, including blinded accounting based databases and “look-through” Freedom of Information Act databases.
With blinded databases, the information is aggregated, so the details of transactions and subsequent returns remain unknown. On the other hand, look-through databases collect summary data via public records under the FOIA and by scouring websites to collect return information, the report said.
An accounting based model for performance measurement benchmarking is preferable as its calculation methodology is more rigorous, noted the report. Look-through datasets can be useful, but tend to be more worthwhile for other aspects of private equity portfolio management.
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