Performance data: In search of a Galilean moment(2)

In order to truly understand private equity’s outperformance potential, the industry urgently needs to develop a better metric than internal rates of return, writes Massimiliano Saccone

There has been a flurry of recent research documenting the outperformance of private equity versus other asset classes and, in particular, listed equities. But rather than proving reassuring, this actually seems to have generated even more scepticism about the industry.

The issue seems to be the quality of the outperformance information – and thus the value and comfort it brings to investors and stakeholders. The principal question, of course, should be how the outperformance itself is measured – i.e. the current private equity benchmarking framework, and how it generates information about the relative performance of private equity versus other asset classes.

To get a better understanding of the problem, it’s worth reminding ourselves that the data in question are derived by comparing private equity internal rates of return (IRR – a money-weighted series of performance data) against listed markets’ rates of return (RoR – a time-weighted series of performance data). Therefore there is an evident apples-and-pears issue that compromises the quality of the information delivered.

But the key underlying problem is that the current private equity valuation system is unsuitable and fundamentally a poor yardstick for performance – because it is based on the principles of IRR, the well-documented flaws of which make it inappropriate for the purposes of ranking and comparing different investments. Its inherent shortcomings rapidly become apparent when one considers that it allows (notoriously) for the possibility that 75 percent of funds can claim to be top-quartile performers.

So from a practical standpoint, if IRR-based benchmarks are based on unrealistic and non-replicable assumptions – and are therefore not investable – it appears that the industry’s own rankings are responsible for private equity’s potentially crisp aura languishing in foggy opacity. And if IRR benchmarking does not create the conditions for correct, objective and fair comparison of the investments being analysed, then the entire system must be called into question.


Benchmarks play a crucial role in financial markets when it comes to asset pricing, and not just by providing the comfort of clear comparisons. If benchmarks are incorrect, valuation, pricing and related investment allocation and risk management decisions are affected and potentially impaired.

For private equity, all the benchmarking environments currently available rely on flawed IRR assumptions that are unrealistic and inadequately informative, at least from a risk perspective. If it isn’t changed, the IRR system will ensure that unnecessary opacity and illiquidity will remain the norm for many years to come.

The recent period of crisis, abruptly following the industry’s fundraising and valuation peak, has brought to light issues that were not dealt with during the previous decades of unquestioned development and growth. As liquidity and risk management become priority items on investors and regulators’ private equity agendas, the adoption of a robust indexing and pricing framework becomes vital.

In order to deal with the perceptions of opacity and ambiguity surrounding private equity, the industry needs to adopt an apples-to-apples benchmarking framework. There is a need for a system to stand independently in the private equity investment indexing arena – one that produces valid and trusted investable indices.


Little flexibility remains as to how such an indexing environment should be built to suit these requirements. As a rational pricing approach needs to go beyond the level where demand and offer meet, particularly in markets that are not adequately developed and liquid, and allow relative value and risk arbitrage considerations, the only framework that can possibly be adopted is a time-weighted one.

By adopting a time-weighted approach, it is possible to properly determine the risk / reward profile of the asset class, or of homogeneous clusters of funds within the asset class. Expressed in time-weighted RoR terms, private equity performance also becomes properly comparable to all other asset classes and across vintages.

Its comparability with the broader category of listed equities, against which its risk can thus rationally be priced, reveals the true nature of private equity: that, contrary to what the hurdle rate convention seems to suggest, it is not an absolute return asset class but a relative return asset class. Allowing for those vital direct comparisons, returns (or prices) can therefore be properly expressed in terms of equity market risk / return (beta component) and the additional risk / return factors (spread).

To overcome the limitations of IRR or multiples, a robust time-weighted performance measurement methodology takes into consideration both time and amounts invested within a duration modeling framework. It also allows for explicit, realistic and replicable assumptions about cash committed but undrawn, and the possibility of leverage or over-commitment.

So a derived Duration-adjusted Return on Capital (DaRC) measure meets all the requirements that make an index robust, realistic and investable (having characteristics consistent with those of the portfolio being measured against it): it is unambiguous, specified in advance and ultimately adequate to create an informed opinion.


But being innovative within the indices space makes sense only if it improves industry conditions and the investment experience for investors. The primary objective is to introduce a measure that is correct, appropriate and realistic. The critical condition for its adoption is that the new approach must yield useful tools including pricing, synthetic hedging, liquidity, and asset allocation instruments.

Within such a framework, the starting point for managers and investors (general and limited partners) is a realistic assessment of the value creation and the premium relative to the listed market over time. With this information, it is then left to investors to determine whether the premium is adequate – and, ultimately, either to hold on to the investment or trade it in as a secondary transaction of the primary investment or a derivative transaction in respect of its market exposure and / or its premium. Which is exactly what happens for all other asset classes.

The alternative to holding the investment, therefore, is no longer just a sale (which is often reactive, delayed and forced). A new possibility is created: to transform synthetically the risk / return profile of the private equity position from symmetric to asymmetric, or to replace the direct position with a synthetic replication, eventually extracting smart beta.

For investors, substantially better conditions to deal with regulators and prove that better risk management analytics and tools are in place (in order to obtain substantial savings related to the cost of capital charges) are therefore created. For general partners, improved fundraising conditions in the institutional market place are created – but also the possibility, given the increased flexibility that is allowed by the derivative instruments, to access wholesale distribution channels.

To use an analogy: once Galileo had empirically proven Copernicus’ assertions that our world was not the centre of the universe, mankind took a great leap forward in mapping the cosmos. Private equity needs its Galilean moment – one that will allow the wider investable universe to accurately place private equity in context, and by doing so, give it its deserved halo. 

Massimiliano Saccone is the founder and managing partner of XTAL Strategies, an emerging leader in the new market of indexed and synthetic solutions that improve price transparency, liquidity, risk management and allocation practices for the investors in private capital funds.