Data doesn’t lie: illiquidity premium doesn’t exist

There is no 3 per cent illiquidity premium in private equity, according to research by CEM Benchmarking.

A cost drag on private assets cancels out the returns of investing in private equity and real estate for those investors that outsource to external providers, the research finds.

CEM Benchmarking, which has a database of 354 pension funds from all over the globe with assets of about $7 trillion, looked at the benchmark and investment returns of those investors in private equity and real estate from 1995 to 2010.

Mike Heale, partner at CEM, says an implementation style factor is overwhelmingly dominant when funds outsource private assets and there is a cost drag of up to 7 per cent depending on the implementation style.

CEM looked at the returns of investors and the benchmarks they were using to measure their performance.

Most are using either peer-return based benchmarks, based on returns of other institutions like those produced by Cambridge, or market-based benchmarks which are not actually investable, such as the S&P500 plus 3 per cent.

In private equity market-based benchmarks dominate, with 71 per cent of investors using such benchmarks. In real estate peer-returns based benchmarks dominate with 68 per cent using these.

But these benchmarks are flawed, according to CEM.

“Most are uninvestable, they have timing mismatches and there are lags in the data and there are smoothing issues,” Heale says. “The valuations are lagged, they don’t reflect reality. And this causes a gross under-statement of risk. There is overwhelming noise in interpreting performance.”

CEM measured the performance of investors against a more “realistic” benchmark it constructed.

For private equity this was blended small cap equity index with a lag of 100 days, and for real estate it was the S&P REIT index with a lag of 200 days.

In private equity the average return of the pension funds in the CEM universe over the 16 year period was 9.3 per cent, compared with the CEM constructed benchmark of 9.2 per cent.

This is an average net value added of 0.1 per cent.

“Only 10 basis points above the benchmark over a 16 year period. The illiquidity premium doesn’t exist,” Heale says.

“Further, style matters. Whether you bother with private equity investments or not, depends on the costs of implementation.”

Those funds that are large and well-equipped to manage private equity internally, added an average of 3.5 per cent above the CEM benchmark over the period.

Pension funds with external managers added 0.2 per cent, and those with fund of fund managers had an average of 7.2 per cent, which was -1.6 per cent against the benchmark.

The results are worse for real estate where the net value added was -1.2 per cent over the period.

The same pattern of decline exists, with internally managed portfolios performing best (NVA of 1.2 per cent) with a sharp decline to external management (NVA of -1.6 per cent) and fund of funds (-3.9 per cent).

The S&P 500 for example, has returned an average of 11.3 per cent over that 16 year period.

Heale says CEM embarked on the research in recognition that funds have a hard time understanding or interpreting performance of private assets due to the fact there is so much noise in the benchmarks.

This year CEM is conducting research looking at the asset class performance targets of its clients.