Earlier this year, an article in Private Equity International posed the question:
“Do investors receive a premium for illiquidity?”
The piece focused on Jonathan Ford’s controversial position that while private equity had historically delivered outperformance compared to public markets (specifically, the S&P 500), since 2006 limited partners (“LPs”) had not earned a premium for locking up their capital in private equity funds. To counter this argument, the PEI article highlights a number of points, including that Ford fails to acknowledge that the time period analyzed in his research, from 2005 onward, “includes the longest bull market in history”. Certainly, repeating this analysis now, or even in a few quarter’s time, would likely present a different story given the correction in the market due to the impact of COVID-19.
Fair and thorough arguments are presented by both sides here, and in fact both articles highlight a singular theme: the importance of manager selection in private equity investing.
The study Ford references looked at 800 US Buyout funds to present an “average” return against a listed index. In reality, no investor will be invested in the entirety of the broad range of private equity funds. There is no “investable index.” Further to that, no investor is simply looking to achieve the “average” return, either.
The key to success in private equity, and private markets more broadly, is fund and manager selection.
A recent study from consultant RVK, sourced via our Nasdaq eVestment Market Lens platform, makes this point abundantly clear. They found that the spread between top and bottom quartile funds in private equity is a whopping 12.9 percentage points compared to 1.5 percentage points for public equities funds.
(Private Investments Primer, RVK, April 10, 2020)
The stark difference in dispersion of returns between public and private equity funds has one logical explanation: long-only asset managers are locked into a finite universe of stocks that can lead to a lack of diversity in portfolios. Contrast this with private equity investing where underlying positions are largely mutually exclusive and each manager’s fund will be largely unique and not replicable by any other manager. This creates more opportunity for outperformance, or alpha, among private equity funds when compared to long-only managers.
The net effect of all this is that LPs are now looking more aggressively for GPs that can produce alpha in the private markets.
But the challenge is that data in the private markets is not as transparent and easily accessible as it is in the public markets, and simply using high-level net return figures is not a reliable strategy for making investment decisions. The calculation methodologies for reported net returns have grown increasingly nebulous and managers are often unable to achieve top quartile performance across multiple funds in a fund series. Simply looking at fund returns does not offer insight into what actually drove performance and how repeatable the investment strategy is.
As referenced in the Private Equity International article: “Sophisticated investors tend to ignore headline performance numbers and request historic cashflow data from prospective GPs, not because they suspect foul play, but because they know headline IRRs and multiples can be calculated in 100 different ways.”
Finding alpha with quantitative due diligence
While a top quartile fund will still catch the eye of an LP, it is by no means a golden ticket to allocations for a GP. Being a top quartile fund in one of the many private equity industry benchmarks seems to be an unwritten requirement in the industry, so for LPs the real challenge of separating the winners from the losers begins when they get a look under the hood during due diligence.
In the search of alpha in the private markets, investors are now conducting far more intense quantitative due diligence during the manager selection process. From IRR recalculation, and normalizing leveraged performance, to cash flow and loss ratio analysis, LPs are digging into manager track records at the deal-level. And as this analysis has grown more sophisticated, so have the tools investors use to complete this quantitative due diligence, tools like Nasdaq eVestment Private Markets.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.