Traditional performance benchmarks to fall short as PE evolves, says CA
Fund-level benchmarks, which institutional investors have relied on for decades to evaluate private equity managers and opportunities, no longer provide a complete picture, according to investment firm Cambridge Associates (CA).
The continued expansion and evolution of the private equity market is challenging the singular usefulness of fund-level "net to limited partner (LP)" benchmarks, it says.
Investors' pursuit of co-investment and direct investments in portfolio companies; increased fee and carry variability across managers and LP investors; and managers' expansion into new strategies and geographies are complicating institutional investors' investment evaluation efforts. Investors need to go beyond fund-level benchmarks to judge managers' true investment ability, says CA.
Enter "investment-level performance benchmarks," which measure the gross performance – before fund-level fees and carried interest are subtracted – of underlying portfolio companies within a sample of private equity funds.
A report from Cambridge Associates, A New Arrow in the Quiver: Investment-Level Benchmarks for Private Investment Performance Measurement, illustrates how investment-level data and analysis can offer new insights that complement traditional fund-level analysis.
"Looking beyond fund-level benchmarks is becoming more and more important for private equity investors. The market has expanded beyond commingled funds with standard '2 and 20' fee structures: today we see lower-fee or no-fee direct and co-investments, we see different fee options for the same fund. Our investment-level benchmarks provide a valuable perspective on whether, and how, an institution's private equity managers add value," says Rich Carson (pictured), senior director of private investments at Cambridge Associates and co-author of the report.
"Investment-level benchmarks represent another arrow in investors' quivers to use when evaluating private equity manager performance," adds Andrea Auerbach, head of global private investments at Cambridge Associates and report co-author.
Cambridge Associates derives its investment-level benchmarks from the returns data of over 70,000 individual investments made by over 3,300 global private equity and venture capital funds. The Cambridge Associates report focuses on the investments made by private equity funds.
Investment-level performance benchmarks allow investors to gain new perspectives along several fronts.
In the past decade, investors considering – or actively pursuing – co-investments or direct investments has grown to be a majority of investors.
"One of the reasons co-investments are so popular is that they offer lower-to-no fees compared to a typical fund structure," says Auerbach. "Yet traditional fund-level benchmarks are net of fees, making them an 'apples-to-oranges' mismatch for benchmarking co-investments. Gross investment-level returns, based on a pool of deals with similar characteristics (e.g. same year of investment, same sector, same deal size) provide a better option for benchmarking these investments."
As investors and funds consider expanding into new sectors, geographies or strategies, they need to understand the returns and risks. However, fund-level benchmarks do not always offer a 'pure' view into the performance of a specific sector or strategy.
"The vast majority of funds invest in deals across sectors; therefore, if you want to understand the performance of investments in, say, the consumer sector, you could look at the net returns of all funds that invest exclusively in the consumer sector, but there are not that many consumer-focused funds," says Carson. "Investment-level analysis provides a more robust universe of data by allowing you to pool all the investments made in a specific sector, whether by consumer-focused funds or generalist funds, and look at the returns and risks of that pool."
Sometimes, the global investment environment can change drastically over the course of a fund's investment period.
"For example, there were funds that were raised and invested across the years of the global financial crisis. A lot of the deals in 2007 underperformed while the deals completed in 2009 and 2010 outperformed, translating to middling overall fund performance," explains Auerbach. "Investment-level performance data looks beyond a fund's vintage year and compares investments made in a specific year to a pool of similar investments made in that same year. This extra layer of performance perspective can meaningfully inform investment decisions."
"Fund-level performance benchmarks – the mainstay of private equity performance measurement – are incredibly important and necessary. But they're not always sufficient in today's evolving private equity environment," says Carson. "Investment-level data can provide 'apples-to-apples' benchmarks for direct and co-investments and they can complement traditional fund-level analysis by providing additional perspectives."