“If you're not benchmarking your performance against your competitors, you're just playing with yourself.” – Al Paison
When someone mentions the term “private equity,” it tends to conjure up images of exclusivity and the business adventures of the super rich. Yet ever more people have exposure to this exotic and rarefied asset class thanks to their pension funds. Most large state pension funds, and plenty of defined-benefit private ones, too, have been drinking deeply from the private equity (PE) well for years.
I have mentioned before how pension administrators, who control many billions of dollars belonging to millions of citizens, have been increasing their allocations to hedge funds and aggressive mutual funds in pursuit of higher returns that can fill yawning funding gaps. The same has been true for other alternative asset classes, with PE featuring prominently in many public and private pension portfolios.
For those individuals sufficiently blessed to be classified as sophisticated investors – which can simply mean being rich enough to lose a lot of money without losing their shirts – PE has been growing in popularity as well. It’s easy to understand the appeal. PE promises to consistently outperform the market and deliver abnormal returns to investors patient enough to place their wealth in a highly illiquid asset class.
Unfortunately for that rosy picture, PE is not so rich in investment alpha as investors might think. Fees have been a subject of considerable debate over the past few years and have formed the core of the controversy around the asset class. I will address the subject of PE and hedge fund fees in another article; there is something far more disconcerting in the workings of PE that gets little attention and needs to be addressed. Specifically, there is no clearly defined or accepted benchmark against which one can measure PE’s performance.
This article addresses why benchmarks matter, how PE funds have misused benchmarks to inflate their relative performance, and what better benchmarks investors might employ when they compare PE to alternatives such as public equities – an essential tool for anyone thinking about taking the plunge and allocating to a PE fund.
The importance of benchmarks
The utility of an appropriate benchmark is fairly obvious: Without one, there is no way to compare the relative performance of a PE fund against other investment alternatives. It is important to understand that simply returning more dollars than, say, an index fund that seeks to mimic the performance of the broader market by tracking something like the Standard & Poor's 500 Index. Return is only part of the equation; risk is also a factor. Only by gauging the level of risk involved in obtaining a certain return can an accurate comparative analysis be made.
PE funds are understood to produce superior risk-adjusted returns. Whether that is true depends first on whether we can measure the risk level and the commensurate risk compensation. If the claims about PE are true, we must first know the level of risk being compensated for. The problem is that funds use neither proper risk measurement methodologies nor appropriate benchmarks.
PE’s lame stalking horse
PE fund managers have known for a long time that the best way to show abnormal positive returns is to stack themselves against benchmarks that can’t hope to compete.
The favored benchmarks within the PE industry are major market-weighted indices, such as the S&P 500. These indices seek to mimic aspects of the market portfolio – i.e., the universe of securities making up the stock market. Yet despite their wide use, broad-based indices make very poor benchmarks for a specialized asset class like PE.
Among academics and researchers who follow the industry, there is a wide consensus that stock indices are utterly inadequate for the task of measuring the risk-adjusted returns of PE funds. Instead, benchmarks must be determined on the basis of the particular mandate of a PE fund and its activities in the market. For example, leveraged buyout (LBO) funds represent a PE strategy with distinctive characteristics. A benchmark for a fund involved in leveraged takeovers of companies cannot be a passive index – the performance of an LBO deal bears no resemblance to the market portfolio in terms of risk or potential reward.
Comparing an LBO fund to the S&P 500 is clearly a case of comparing apples to oranges. Yet, despite both the obvious lack of comparability and the admonishments of empirical researchers, the PE industry has not budged. That would not necessarily be a problem, if allocators were ignoring industry-preferred benchmarks in favor of their own due diligence. But that does not happen in practice, alas. Instead, pension funds, family offices and individuals by and large accept PE funds’ own benchmarks at face value.
Building better benchmarks
Perhaps the saddest part of the problem is that a lot of work has already gone into producing alternative benchmarks that correct for many of the issues of industry-favored benchmarks, yet they get little use in practice. I understand investors’ natural skepticism of cloistered academics (who could ever forget, or forgive, the insult that is the random walk?), but their work on PE benchmarking is worth a closer look.
One method that has been popular among researchers for years, but that has gotten meager attention from either PE fund managers or allocators, uses a net present value-based model that treats the returns of publicly traded equities as a discount rate. This methodology is built on the sound notion that the performance of a PE fund should be assessed on the basis of its net-of-fees returns compared to the net-of-fees returns of the best implementable alternative strategy – i.e., the best benchmark against a PE fund is what the next best investment opportunity, within broadly the same mandate, would have delivered.
Taking a real world example, consider the case of an LBO fund. We know the S&P 500 is definitely not an appropriate benchmark. Instead, we might consider using the historical performance of something with characteristics far more similar to an LBO fund, such as that of Dimensional Fund Advisors’ (DFA) micro-cap and small-cap mutual funds.
On its face, DFA’s funds seem to be far closer in character to an LBO fund than is the broader market. They are invested exclusively in small companies in the “value” category, the same companies LBO funds typically target. The data bear out the similarity, proving it to be far from superficial: In a time-series analysis, LBO fund returns and the returns of DFA mutual funds with small-cap mandates show a very high level of correlation.
Beware of funds bearing gifts
Using this alternative benchmark casts LBO fund performance in a very different light compared to using the S&P 500. While using the S&P as a benchmark would suggest that LBO funds outperform the market by around 4%, using the DFA micro-cap fund in its place shows LBO funds underperform by more than 3%.
The implication is that LBO funds represent little more than leveraged exposure to small cap value companies; the underperformance of the LBO fund would then be explainable as its cost of fees compared to those of a mutual fund that is low-cost and largely passive. That ought to give an investor pause before jumping into a PE fund – they could instead take a more liquid, lower-cost alternative in the form of a leveraged investment in a small-cap or microcap value fund.
Of course, there is no one-size-fits-all approach to identifying an appropriate benchmark. Yet failing to do so, or opting for simplistic and inaccurate benchmarks over more robust choices, can lead to poor outcomes.
If investors genuinely seek superior returns, they have to be willing to work for them – and the first step is to establish accurate benchmarks. Without them, they will end up paying high prices for subpar results.
