How should asset owners benchmark their private equity exposure?
Many of the biggest asset owners benchmark their private equity investments against a public markets index. This has led to the impression of horrific underperformance, but are they doing the right thing?
Good morning. How should asset owners measure their performance when they invest in private equity?
This is a pertinent question as many asset owners increase their exposure - either because they want to do so or because a government is gently encouraging them to.
It’s easier to answer in respect of North American asset owners than elsewhere, simply because they are more open about it.
So how do some of the biggest US pension funds benchmark their private equity holdings?
Largely against a public markets benchmark, but some use a custom private market benchmark and some use a combination of the two.
However, public markets have obviously been having a great time lately, which means tough conversations about private equity performance - but the correlation doesn’t always run from strong public markets benchmark to horrific underperformance:
Often those who use a public markets benchmark add some sort of hurdle. Florida’s State Board of Administration, for example, uses a global equity index plus a fixed return of 250 basis points a year.
Some of the funds that use a public markets benchmark employ a combination of different indices and formulas so complex it would take several paragraphs here to explain.
So who has got it right? Counterintuitively, Jill Shaw, a partner at Cambridge Associates, said the funds that use a public markets benchmark are on the right track (with a few caveats).
Shaw, who has published a paper on benchmarking private assets, said: “The basis for the argument that public equities are the appropriate benchmark comes back to the question, where would the money have otherwise been invested if you did not access private markets.
“If the money would have otherwise been invested in public equities, that is the opportunity cost.
“Our belief is that you should not be allocating dollars to private markets unless you believe you will outperform public markets. There has to be a premium.”
She parts company with some of these funds on the use of constructed benchmarks with hurdles such as inflation.
Shaw said: “Our view is that the use of constructed benchmarks is trying to create a false precision that doesn’t necessarily tell you anything about what you've done differently or would have done differently.
“For example, one of the things that some organisations do is set the equity markets as a benchmark and then add a hurdle to incorporate an ‘illiquidity premium’ on top of that.
“Nowhere else in your portfolio would you expect that. You wouldn’t add a hurdle to the benchmark to account for the expected premium of an active public strategy. Plus, a benchmark with a premium is not investable, you can’t invest in the MSCI ACWI plus an illiquidity premium. Again, the opportunity cost is the investible alternative.”
All that’s left is for asset owners to hope public markets revert to the mean.
