Investors put private equity performance under the microscope

Investors are seeking better performance attribution in private markets to better understand underlying return drivers –  especially in private equity, where metrics such as IRR or multiples are increasingly criticised for being opaque.

Investors are seeking better performance attribution in private markets as their growing allocation to unlisted assets demands a better understanding of underlying return drivers, especially in private equity where opaque metrics such as internal rate of return or multiples are no longer sufficient.  

At the Fiduciary Investors Symposium at Harvard University, Sofia Gertsberg, HarbourVest managing director, made the case for the Brinson-style performance attribution used in public markets investing to be applied to private equity.

The Brinson model breaks down the active return of a portfolio into specific management decisions, examining the effects of allocation, selection and interaction as decisions.

In a proprietary model, HarbourVest refitted the Brinson framework to private markets using deal-level benchmarks, allowing investors to distinguish between the different factors, like sector allocation expertise or value creation in portfolio companies, which may have driven a GP’s excess return.

“[We] understand that the lack of benchmarking is a real challenge, and it’s impossible for investors to actually answer the question of whether my manager has delivered skill or were they really lucky and just benefited from industry tailwinds,” Gertsberg told the symposium at Harvard University.

The manager recently partnered with M. J. Murdock Investment Trust to dissect the return drivers among its 76 primary buyout and venture capital commitments between 2012-2022. With 2.35x total value to paid in (TVPI) during the period in the two asset classes, the analysis found that the alpha was disproportionately driven by venture whereas buyout only contributed modest value-add.

Elmer Huh, chief investment officer of the foundation, said the weighting of value-add which came from venture was “surprising”.

“It’s important to understand that as human beings we’re all fallible, and we have these gut instincts if we’re really in tune with our portfolio,” he said.

“[But] beyond that, to go to a second level order is to say to what degree did venture [performance] depend on one manager or several managers, vintages, regions and stage.

“We have our intuition, but these are bridges and graphics to illustrate to us what are the additional questions we need to be asking to help us refine and get more comfortable with where we’re making decisions in the future.”

Understanding private markets’ performance on a more granular level also helps investors better define their roles on a fund level, Huh said.

“We can make it an example to say, ‘we had for a long time a small-cap manager, but there was like a 90 per cent correlation with our lower-middle-market private equity’,” he said.

“Why would we want to do that? Then it comes back to the questions we’re supposed to be asking, which is what’s our long-term [thesis]? What’s our duration? What’s our horizon period?

“Tools are tools; they should help you ask the right questions, they should help you uncover… the unintended bets that you’re making.”

Margaret Franklin, former president and CEO and current senior advisor of the CFA Institute, said that, apart from attribution, benchmark selection is another factor that could muddle the evaluation of performance.

“You can have the same fund, the same manager, and depending on your benchmark selection, investors could come to really quite different conclusions about those funds,” she said, adding that, for example, investors can have benchmarks of different time horizons against which they evaluate private market investments.

The inefficiencies in private markets’ asset classes that early mover investors have been taking advantage of to secure outsized returns are also waning, Franklin said.

“I think that’s where the demand for more reliable, transparent, and comparable information becomes critical – to be able to do better analysis and not just for the most sophisticated investors, but more clearly for the broader population that’s investing in it.”