Key Points:
- Private market performance calculations often tolerate mathematical errors and inaccuracies.
- The variability of cash flows makes performance attribution challenging in private market assets.
- Metrics such as internal rates of return (IRRs) and total values to paid in (TVPIs) are not suitable for generalization.
- Accurate performance comparison requires time-weighted metrics and information about capital invested.
- Misrepresentation and data distortion occur in money-weighted quartile information and rankings of private market investments.
- Additivity is essential for robust statistical analysis in private equity return calculations.
- Pooling cash flows from different funds can create significant data distortion.
- The duration-adjusted return on capital (DaRC) methodology provides a more accurate framework for performance analysis.
Private market investors, advisers, academics, and enthusiasts often tolerate mathematical errors and inaccuracies when evaluating private market performance. Unlike traditional asset classes, where investment professionals meticulously analyze every aspect of performance, private market assets are subject to excessive approximation.
The variability of cash flows in private market assets makes performance attribution more challenging. Unlike stable underlying assets in traditional investments, private market returns cannot be reinvested or compounded. The current performance attribution toolkit, including metrics such as IRRs, TVPIs, and PMEs, works at the single asset level but cannot be generalized.
Generalization, in non-mathematical terms, allows for meaningful comparisons. To determine whether a certain IRR or TVPI is objectively better than another, additional data about time and capital invested is necessary. Time-weighted metrics, rather than money-weighted approximations, provide a more accurate basis for comparison.
For example, a 10% IRR may be preferable to a 15% IRR if it is earned over a longer period of time. The duration component is essential to reach a reasonable conclusion. Additionally, assumptions about reinvesting money recouped earlier at the same rate of return are not guaranteed in private market investments.
Money-weighted quartile information and rankings of private market investments can create significant data distortion. Metrics such as PMEs and alphas suffer from conceptual limitations, as they do not consider the real capital deployed versus the capital committed to be deployed.
In mathematical terms, additivity is a precondition to any robust statistical analysis. Averaging rates is only possible through compounding, which the IRR cannot accurately achieve over time. Therefore, without accurate additivity and capital utilization information, representative averages cannot be determined.
Aggregated private equity return calculations often pool cash flows from different funds as if they were from a single fund. This practice further distorts the data and does not consider the mathematical accuracy or representativeness. Annualized differences in performance are dealt with without proper consideration.
To maintain accuracy in private equity performance analysis, the duration-adjusted return on capital (DaRC) methodology provides a framework. It corrects multiples by considering the timing of cash flows and leverages the additivity attributes of duration. This approach ensures that the pooled multiple remains in line with actual cash-flow balances and provides a credible average net time-weighted DaRC return.
Accurate performance numbers are essential for optimizing allocation and risk management in a diversified portfolio. The current private market metrics often fall short of providing reliable benchmarks, but improvements can be made.
