evaluating performance without established benchmarks

Mutual funds use benchmarks to assess and communicate performance. These benchmarks typically have several common criteria:

• Like mutual funds, the benchmarks are investable portfolios; for example, the S&P 500.
• They are measurable; one can calculate the returns readily and objectively.
• They have similar qualities and investment philosophies as the funds themselves, enabling “apples-to-apples” comparisons.
• They have clarity in composition; that is, the actual securities included in the benchmark portfolio are known and their weights are clear.

Private equity funds, however, do not have true benchmarks that fulfill the criteria above—largely because a private equity “market” does not exist. Traditionally, private equity fund managers have evaluated their funds and portfolio companies using subjective processes that are not marked to market.

Measuring a private equity fund’s return.
There are two ways to measure a fund’s return.

Regular return measures the growth of the initial principle over a period of time. This formula is effective for calculating the time-weighted return of an asset at the end of a period. In the case of private equity funds, however, calculating the return of a fund at the end of each period (for example, quarter or year) can produce misleading results because the final value of the fund is, at best, a guess based on subjective valuation rather on what the market would pay to liquidate. Because the private equity fund manager controls cash flow and a true market price is not available, this method typically is not used for private equity funds.

A more popular method for private equity funds—and, in fact, a mandate of the CFA Institute—is to measure internal rate of return (IRR) because it does take into account the timing of cash flow. It is worth mentioning that, in other performance reporting scenarios, IRR is not recommended as a financial measure due to some inherent limitations; namely, because multiple IRRs—which are common in cases involving complicated patterns of cash flows—can lead to a net present value of zero.

Evaluating private equity fund performance.
Once a manager has calculated a fund’s return, how can he or she assess its performance? There is no widely accepted industry standard for evaluating fund performance. Rather, there are four possible solutions with varying degrees of complexity.

Multiple indices and methods. As the name implies, this approach utilizes several indices and methods to compare a fund’s IRR with the cost of capital derived from the indices. The Cambridge Associates (CA) and Sand Hill (SHE) indices are commonly used for this type of comparison.

Upper and lower bounds. This approach is similar to the multiple indices and methods approach, except that it uses an upper bound (typically the CA index) and a lower bound (typically the SHE index) to compare IRR to the cost of capital.

Pastor-Stambaugh model. Like the similar Fama-French model (FFM),Pastor-Stambaugh is based on the arbitrage pricing theory that models a fund’s performance in correlation with multiple market factors. Unlike the FFM model, the Pastor-Stambaugh model takes into account a liquidity factor (private equity funds typically are highly illiquid), capturing the private equity asset’s return more accurately.

Limited report time. This approach only calculates return during the middle part of a fund’s life to avoid the J-Curve effect—an effect caused by negative returns in early periods due to payment of management fees and start-up costs, followed by a period of steep returns and later (usually after three to five years) by returns that more closely represent the actual IRR of the fund as a whole.

Most firms tend toward the “easier” approaches; however, it is important to consider operational factors such as cash management before determining a performance reporting approach. Each of these approaches has its advantages and disadvantages. Fund managers, therefore, should take time to understand these approaches to ensure that they are using the one that best meets the characteristics of the fund’s assets and investors’ needs.

West Monroe Partners works with private equity firms to assess, improve, and report performance. For more information, please contact Munzoor Shaikh.