PE performance benchmarks need to evolve

LPs are changing their approach to PE performance as they seek to ensure ongoing alignment with GPs.

Pensions, foundations and limited partners are increasingly using public and customised benchmarks to determine how GPs fare, said panellists at a Burgiss webinar.

Barry Griffiths, a partner at Landmark Partners, said during the LP Best Practices: New strategies in benchmarking PE/VC returns webinar that while historically LPs have used total value to paid-in and internal rate of return to measure performance, there has been a move to use tools such as “direct alpha” to compare the performance of illiquid funds with broad public market benchmarks.

The direct alpha algorithm, which Landmark originated five years ago, is made up of two main components: private portfolio cashflow and a public benchmark. Simply put, it is directly calculated based on the series of private equity cashflows that are capitalised by single public market benchmark returns, such as the MSCI World or S&P 500, to the same single point in time. When using direct alpha, LPs can also opt to use custom benchmarks that closely reflect the portfolio. Examples include industry-weighted S&P 600 for small-cap exposure or levered industry-weighted S&P 600 to reflect the financing actually used.

Participants noted that LPs also need to take into account structural considerations, including how fees are charged, the structure of funds themselves and cashflow dynamics. What’s more, the increasing use of subscription lines of credit makes it easier for GPs to manipulate fund performance.

Tim Jenkinson, professor of finance at Oxford University’s Said Business School, said the most relevant way of judging PE performance is relative to public markets.

Looking at Burgiss fund data up to end-2014, which includes more than 2,000 buyout funds with about $2.5 trillion of committed capital, Jenkinson found that except for 2008, there hasn’t been any year where buyout funds, net of fees and carry, have not beaten public markets. This means since 2008, even bottom quartile buyout funds have been in the carry.

“If you are an LP starting to think about measuring returns relative to private markets, then doesn’t one want to think more carefully about whether the asset class really has a high level of alignment of interest when you can have vast majority of funds actually being paid carry, not really through skill but just through the rising tide of public markets?” Jenkinson asked.

This is one reason why there will have to be a re-assessment of the deal between GP and LP, he added.

“Ninety percent of funds being paid carry doesn’t seem very aligned to me,” Jenkinson said.