For limited partners investing in private equity, picking so-called “top-quartile” fund managers can be tricky.
Analysing the performance of funds managed by general partners raising follow-on funds can be especially misleading, as predecessor funds are almost always too early in their investment cycle to accurately predict ultimate performance. Furthermore, fund managers have been known to inflate their net asset values during fundraising times as a way to help raise capital. A recent study from the University of Oxford examined the California Public Employees’ Retirement System’s portfolio of 761 private equity funds going back to 1990 and 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”.
However, a new study from Landmark Partners demonstrates that factoring in “public market equivalent” data can help predict the ultimate performance early in the life of private equity and venture capital funds.
“The public market equivalent looks at what happened in the public equity market between the times of drawdowns and distributions and normalizes a fund’s returns to remove the effect of these general market movements,” the study says.
“As a result, [the] public market equivalent measures the additional value that was eventually contributed by the fund manager.”
The study used the unlevered S&P 500 Total Return index as it measure of public market returns.
By using the public market equivalent “as a measure of success, we show that interim and final public market equivalent of buyout funds have a systematic relationship already at the time a successor fund is raised”, according to the study. “We can use the public market equivalent early in a buyout fund’s life to identify managers who systematically add value beyond what can be easily obtained from the public market.”
LPs are therefore “much more likely” to back outperforming GPs by relying on the public market equivalent “as a measure of a fund’s interim success”, the study says.
One caveat of the study is that LPs still need to take into account how GPs generated their public market equivalent-adjusted performance, “and whether it is reasonable to think that the fund manager can achieve something similar in the future”.