Performance measurement in private equity has always been something of a conundrum.
Aside from the fact that nearly every firm bills itself as ‘top quartile’, private equity has endured a seemingly endless debate about the efficacy of metrics used for benchmarking and other performance-related analysis.
The lack of a comprehensive database and a commonly accepted method of assessing performance has meant that fund managers can, to some degree, get away with skewing their performance data. A University of Oxford study conducted last year, which examined the California Public Employees’ Retirement System’s portfolio of 761 private equity funds going back to 1990, found that “valuations of remaining portfolio companies, and therefore reported returns, are inflated during fundraising, with a gradual reversal once the follow-on fund has been closed.”
Limited partners, however, are wising up to these practices – and they’re increasingly looking for better ways to measure GP performance.
“Many concerns have come on to the radar of institutional LPs in the last 12 to 18 months that lead their investment boards to say: ‘We can’t throw the money over the wall anymore and expect good results; we’ve got to take responsibility and have robust verification and internal evidence to make investment decisions,’” says Christopher Godfrey, partner at CEPRES, a private equity benchmarking and analysis platform for LPs and GPs.
One of the tools that has grown in popularity in performance measurement recently is the public market equivalent (PME), a metric that looks to provide a comparison with what happened in the public equity market between the times of drawdowns and distributions, the idea being to weed out the impact of general market movements.
“We’ve had a dramatic increase in requests on sector-level indexes, loss rates, PME and other asset driven analyses,” Godfrey says. “We’re getting a lot of interest at the moment in sector and country specific public market equivalents, whether it’s looking at infrastructure or industrials or clean energy etc. They’re mostly coming from LPs [such as] insurance companies, pensions, endowments and a lot of them from North America.”
A GRADUAL PROCESS
A number of PME calculations have been incorporated into LPs’ analyses, the most frequently cited version being the ‘PME Multiple’ that stems from a paper published in 2005 by Steven Kaplan, the Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business, and Antoinette Schoar, Professor of Entrepreneurial Finance at MIT Sloan School of Management.
“Over time more and more LPs pay attention to those measures because at the end of the day they’re in private equity to beat public equity, and you want to measure that,” says Kaplan. “It’s one of these things that is gradual. I wrote ‘Kaplan and Schoar’ 10 years ago and people are using it more now. Conceptually it makes a huge amount of sense, so I think over time more and more people will use it.”
Josh Lerner, a private equity scholar who holds the Jacob H. Schiff Professor of Investment Banking chair at Harvard Business School, agrees that increased adoption of PME calculations is part of a wider trend toward more effective measures of private equity performance measurement.
“Most of the sophisticated practitioners as well as most of the academics would probably agree that PME represents the first step, and is a better way for evaluating things,” he says. “I’ve already seen instances of groups in [their] fundraising documents doing PME calculations alongside IRRs and multiple calculations. So certainly I think this is an area where one is going to see more activity and multiple calculations.”
However, what works for academics studying private equity doesn’t always translate instantly as far as GPs and LPs are concerned.
“This is clearly an area with a lot of moving targets, and one where there has been an enormous amount of academic research and a lot of interest from private practitioners, though the two have not always seen eye to eye,” Lerner says. “There’s still a big gap between academics and something that, if I was sitting at a sovereign fund in the Middle East or China, I could go and implement. In some sense the science is still sort of exploratory, and it’s probably a little too soon to be putting all these insights into practice.”