Key Points:
– The private equity (PE) sector has more ways to calculate alpha than any other asset class.
– Investing in the average private market fund often yields poor returns.
– The reputation of PE beta is influenced by the Yale Endowment Model.
– Private market alpha metrics fail to reflect the only true definition of alpha.
– The absence of a private market beta leads to “alpha-flation” and distorted expectations.
– Proper private market benchmarks are necessary for accurate alpha measurement.
– The mean PE fund is not necessarily bad, and fund underperformance can be explained by relevant vintage indices.
– The alpha-flation of private market narratives may have unintended consequences for the industry.
In the private equity (PE) sector, there are numerous ways to calculate the alpha of a portfolio or fund. However, investing in the average private market fund often results in poor returns. This raises the question of whether the average private market fund is truly a bad fund, and if so, why.
In other asset classes, the average fund is one that meets its minimum threshold. It is not considered exceptional, but it is expected to beat a relevant index or beta reference on a rolling basis and on key investment horizons. This is no easy task, but it is the expectation.
The reputation of PE beta, however, has been influenced greatly by David Swensen and the Yale Endowment Model. According to a Yale financial report, Yale has never viewed the mean return for alternative assets, including private equity, as particularly compelling. The attraction of alternatives lies in the ability to generate top quartile or top decile returns. This has created an emphasis on picking winners in the highest deciles, assuming wide dispersion of returns. However, PE quartiles are often meaningless, and dispersion is further exacerbated by the internal rate of return (IRR) assumption on which these concepts are based.
The common narrative around PE alpha is focused on picking winners and generating superior returns. GPs often emphasize the alpha they generate, but what about the alpha perspective of allocators, limited partners (LPs), and their advisors? Human nature and a combination of emotional biases and cognitive errors play a significant role in the behaviors and decisions of financial market participants.
Stakeholders in private market investments have certain pre- and post-investment requirements, as well as behavioral biases, such as anchoring, regret aversion, and illusion of control, that need to be addressed. They demand assurance and reassurance, especially when making expensive and irreversible investment decisions in long-term illiquid assets. Alpha, as the ultimate outperformance seal, is expected to meet that need.
One of the main challenges in measuring private market alpha is the absence of a proper private market beta. Traditional benchmarks for private market investments have not been readily available, leading to the development of different alpha-like metrics that reference public market beta or unrelated market metrics. These deal-specific metrics, including the direct alpha method, KS-PME, and excess value method, have inherent limitations and cannot be properly generalized or considered accurate benchmarks.
Academics and data providers have proposed alternative metrics to gauge PE alpha, but they have not overcome the limitations or achieved a one-to-one correspondence between actual monetary amounts and compounded rates generated by algorithms.
Recently, practitioners have shifted the focus of alpha to the probability of outperforming required investment returns. While this approach aligns with the absolute return nature of PE, it may be more of an escape hatch than a solution to the alpha puzzle.
The risk of these definition drifts for stakeholders is that allocators may create self-referential benchmarking tools that lack objectivity in the investment and reporting process.
Proper private market benchmarks are necessary to accurately measure alpha in private equity. These benchmarks should be robust and representative, built in time-weighted terms, and capable of producing a one-to-one correspondence to the actual cash and net asset value (NAV) balances of the underlying constituent fund portfolio. The Duration-adjusted Return on Capital (DaRC) methodology and related indices aim to provide these benchmarks and leverage the characteristics of private market beta and the market risk profile in private market investments.
Analyzing the data, it becomes clear that the mean PE fund is not necessarily a bad fund, and the mean return has not been bad over the observed 25-year period. Even fund underperformance can be explained by the relevant private market vintage index, which represents the mean fund. Investing in blind pools is challenging, and indexed diversification can help mitigate some of the risks.
However, the alpha-flation of private market narratives creates significant distortion. It generates outperformance expectations that do not accurately represent the total return management style of private market investments. This distortion could have unintended consequences for the industry, especially now that less-sophisticated retail investors are gaining greater access to the asset class.
In conclusion, proper private market benchmarks and a clear understanding of alpha are essential in private equity. The mean PE fund is not necessarily bad, and fund underperformance can be explained by relevant vintage indices. The alpha-flation of private market narratives poses risks and challenges to stakeholders and the industry as a whole.
