In private equity (PE), there are more ways to calculate the alpha of a portfolio or fund than any other asset class. And in no other sector than private markets does investing in the middle fund seem to be doing so badly.
Should this be so? Is the average private market fund a bad fund and is the average private market return a bad return? And if so, why ?
In all other asset classes, the average fund is the one that reaches its minimum threshold. The average fund is therefore not “exceptional”. Although, to be sure, beat a relevant index or benchmark beta on a rolling basis, over key investment horizons, is no easy task.
Some time ago I wrote about private capital beta And internal rate of return (IRR)-alpha but the alpha narrative still hasn’t changed. What explains the bad reputation of PE beta? The undeniable influence of David Swensen and the Yale Endowment Model is a critical factor.
“Yale has never viewed the average return of alternative assets as particularly compelling. The appeal of alternatives lies in the ability to generate first quartile or first decile returns. As long as individual managers exhibit substantial return dispersion and As high-quality investment funds significantly outperform their less-qualified peers, Yale is seizing the opportunity to produce attractive endowment returns and demonstrate that manager alpha (excess return) is alive and well.
The Alpha Narrative therefore consists of choosing the winners, possibly those in the highest deciles, assuming a wide dispersion of returns. Too bad the PE quartiles are meaningless and the dispersion is exacerbated by the implicit IRR reinvestment assumption on which these concepts are based.
Private Market Alpha Syndrome
Marketing will always focus on superior returns and alpha generated by GPs. This is widely understood and easily overlooked. But what about the alpha uptake of dispatchers, limited partners (LPs) and their advisors?
Here, human nature bears a great deal of responsibility, as does a combination of emotional biases and cognitive errors, which can affect the behaviors and decisions of financial market participants.
It may be necessary to address investors’ and stakeholders’ pre- and post-investment requirements – and their behavioral biases, such as anchoring, regret aversion and illusion of control – behind the development of several measures of control. alpha for private market investments by dispatchers and advisors.
Stakeholders demand insurance and reinsurance, especially with regard to often costly and difficult to reverse investment decisions in long-lived illiquid assets. Alpha, as the ultimate outperformance seal, should fill that need.
Lack of private market beta leads to alpha-flation
The fact is that the various measures of private market alpha do not reflect the only definition of alpha which should apply to financial investments: The excess return of the specific investment over the relevant representative benchmark. In the case of the PE, this means an accurate beta of the private market.
Since accurate and representative benchmarks for investments in private markets have not traditionally been available, dispatchers, advisers and academics have devised different alpha-like measures. Most of them refer to public market beta or, in some cases, completely independent market measures.
THE direct alpha method is the main measure of “financial alpha” outperformance in the private market. Often associated with the KS-PME, it has recently been supplemented by the excess value method. The direct alpha method delivers a rate of outperformance relative to a listed benchmark, while the KS-PME method generates a ratio and the excess value method the associated monetary amounts. The KS-PME was indeed introduced to fill in some of the gaps left by its predecessors. Nevertheless, all of these measures have the same inherent limitation: they are transaction-specific, so their results cannot be properly generalized. Without checking this box, they cannot be considered appropriate references, or their definition of alpha considered accurate.
Academics and data providers have proposed other measures to assess PE alpha. But these have not overcome the limits of generalization or achieved the necessary one-to-one correspondence between actual monetary amounts and the compound rates generated by the algorithms.
More recently, practitioners have shifted the focus from alpha to the likelihood of outperforming required investment returns. This is an interesting and consistent approach given the absolute return nature of private equity. Still, it looks more like an escape hatch than a solution to the alpha puzzle.
All in all, the risk of these drifts in definition for the stakeholders is that the dispatchers create self-referential benchmarking tools that do not bring the necessary objectivity to the investment and reporting process.
What PE Alpha Should Be in Private Equity and What It Needs
As in other asset classes, PE alpha should measure outperformance as Burton G. Malkiel did in A random walk down Wall Street. Malkiel said, “A blindfolded monkey throwing darts at the financial pages of a newspaper might select a portfolio that would do as well as one carefully selected by experts.”
In other words, positive alpha is produced when a discretionary private markets allocation beats a rules-based diversified allocation in a consistent cluster, over a consistent time frame, on a fully diluted basis, and under no-arbitrage conditions.
This calculation is possible with robust and properly representative private market benchmarks that are constructed in time-weighted terms. These should be able, through capitalization, to produce a one-to-one correspondence with the actual cash and net asset value balances of the underlying constituent fund portfolio.
This is one of the fundamental objectives of the Duration-adjusted return on capital (DaRC) methodology, which is an essential element for proper PE benchmarks. The DaRC and associated indices allow users to determine appropriate alpha and take advantage of the characteristics of private market beta and market risk profile in private market investments.
The average PE fund is not a bad fund, according to our analysis, and the average performance has not been bad in the 25 years we have observed. Indeed, we have found that even a fund’s underperformance can be explained by the vintage index of the relevant private market (i.e. the average fund). Investing in blind pools is difficult, and the strong statistics provided by indexed diversification can help.
The alpha-flation of private market narratives creates a significant distortion. It generates expectations of outperformance that distort the style of total return management of investments in private markets. This could create unintended “boomerang” consequences for the sector, especially now that less sophisticated retail investors have greater access to the asset class.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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