Benchmarking in the Private Markets: The Four Minute Mile

One million albums sold. Zero to sixty miles per hour in three seconds. Or, if you happen to be visiting Hamilton Lane’s Philadelphia HQ, John’s Roast Pork for cheesesteaks, Vincent Fumo for political corruption, and Sam Hinkie for excellence in general managing.

All of these things are benchmarks: a measuring stick we use to assess the relative success or failure of a venture. Some benchmarks are better and more objective than others. It’s easy to get two Philadelphians to agree that running a mile in four minutes is fast, but good luck getting them to agree on the best spot to order a cheesesteak (though most would agree that the roast pork sandwich, not the cheesesteak, is the true king of Philadelphia sandwiches). 

In investment management, benchmarking is a critical part of assessing an investment portfolio. How else would you know whether the 10% return your public equity portfolio generated last year is cause for celebration or cause for reevaluating how your portfolio is managed? In a vacuum, that 10% return may sound attractive. But, if a global listed equity benchmark (the MSCI ACWI in this case) returned 33% in the year leading up to July 30, 2021, that 10% return may not sound so good.

Anyone doing research on investment management benchmarks has likely stumbled across the CFA Institute’s criteria for an ideal benchmark. We’re not the first group to show these criteria (and we won’t be the last) but we’ll repeat them here since they’re important:

Source: Bailey, The Journal of Portfolio Management, Spring 1992

Commonly used benchmarks for publicly traded assets, like the S&P 500, the Russell 3000 or the Barclays Aggregate Bond Index, meet the criteria above. There is a menu of quality benchmark options available for nearly any style (geographic specific, sector specific, etc.) of public market investment. 

But what about benchmarks in private markets? We’ve been investing in private markets at Hamilton Lane since Boyz II Men’s first platinum album was released, so surely you would assume that we have come across a private market benchmark in our 30 years of existence that checks all of the boxes above. 

We wish that were the case. Thus far, all private markets benchmarks have failed to fulfill the CFA criteria. Most private markets benchmarks are not, in practice, investable.  The composition of some private markets benchmarks is ambiguous. There is disagreement among the private markets community on what is the “best” performance or technique metric to use. What gives?

The Data Challenge

Easily the highest hurdle to creating a consensus, high quality private markets benchmark is the scarcity  of private markets fund performance data. The private markets are an asset class where detailed, high quality performance data is incredibly difficult to come by. For all of the potential benefits private markets investments may offer investors, it is the worst asset class for data and transparency. 

For this discussion, we’ll focus on the challenges associated with benchmarking private markets funds. While co-investments – direct investments in private companies made by the end investor rather than through a traditional fund manager – have gained in popularity in recent years, most investors still get the majority of their private markets exposures through private markets funds.

Most regulatory codes stipulate only spartan reporting requirements for private markets funds. More recently, many general partners (GPs) have acquiesced to investor requests to provide additional data. However, historically, GPs have been loath to report much more than the bare minimum required by law. The bare minimum typically involves issuing capital calls or distribution notices as needed, reporting  aggregate fund net asset value on a quarterly basis, and providing a list of the fund’s investments. That information is only reported to the limited partners (LPs) that are invested in the fund.

So how do data providers collect data on private markets funds if all of the crucial information is not directly reported to the general public? While the industry has made it difficult to collect data, it’s not impossible:

None of these methodologies are perfect. Some limit the level of detail that can be collected. Others are difficult to execute or audit. No data provider has yet been able to capture data on 100% of the market. Private markets benchmarks are the Rocky V of benchmarks.

Approaches

The relative dearth of private markets data does not mean that benchmarking exercises for private markets portfolios should be ignored. On the contrary, it makes developing a benchmarking plan even more important. 

Our benchmarking philosophy is that the benchmark that you select for your private market portfolio should reflect the goals, needs, and constraints of that same portfolio. There are two pieces to executing that benchmarking philosophy: public market comparisons and private markets comparisons. We recommend using both techniques to assess different aspects of the portfolio.

Public Market Comparisons

Public market comparisons help investors evaluate the success of their private markets portfolio relative to other asset classes. In other words, they help evaluate the opportunity cost of foregoing an investment in publicly traded instruments in order to make an investment in a private markets portfolio. Public market comparisons can also be used to evaluate whether a manager has demonstrated investment skill or whether managers are a beneficiary of rising global markets. The challenge with public market comparisons is that private market returns are usually quoted using a different metric (IRR) than public market returns (time-weighted return, or TWR). Experienced analysts are careful to avoid mismatched comparison metrics, using one of the two techniques below to put these two asset classes on an equal playing field. There are two computational techniques for evaluating private markets performance relative to public market indices. The first is by using time-weighted return. When a TWR benchmark is used, the analyst is attempting to quote private market returns in the same manner that public market returns are usually quoted. TWRs in private markets are calculated on a quarterly basis since interim valuations are reported quarterly. Those quarterly TWRs can then be compounded and annualized in order to produce an annualized TWR over the desired time horizon.

The second method, perhaps more popular with academics and practitioners, is called a public market equivalent (PME). This methodology takes the opposite approach – it tries to quote the public market returns in the same manner that private markets returns are usually quoted. The first PME methodology was developed by Austin Long and Craig Nickels and the mechanics were intuitive: any time a capital call occurs, simulate a share purchase in the desired reference index; any time a distribution occurs, simulate selling shares in the reference index. The purchases and sales will result in a share balance, the value of which is determined by the index price as of the date performance is being calculated. In mathematical shorthand, the value of the simulated share balance is:

NAV PME= Σ FV(Contributions)-Σ FV(Distributions)

The PME return is determined by calculating the IRR of the private markets portfolio cash flows plus the value of the simulated share balance.

Is one of these two computational approaches superior? That depends on the situation. At Hamilton Lane, we use both TWR and PME to benchmark portfolios, though the use cases for those metrics are different. In general, TWR is appropriate for benchmarking mature portfolios with a relatively constant amount of capital at work. Many LPs also prefer TWR as a shorthand, straightforward benchmark since, given that most other assets in their portfolios are evaluated on a TWR basis, it fits within the framework used for benchmarking the rest of their portfolio. TWR does not work well for benchmarking immature portfolios or for benchmarking individual managers due to the way the annualized TWR calculation equally weights all periods – even periods where very little capital is at work. For those scenarios, a PME approach would be more appropriate. PME can also be used on more mature portfolios, and we believe is therefore often the safer approach to benchmarking.

Private Markets Comparisons

The second component of our benchmarking philosophy involves comparisons of a private markets portfolio to the private market industry, otherwise known as peer set benchmarking. This analysis gives the LP a view of how well its private markets portfolio is performing relative to the other choices it had within the asset class. Has the LP been a good fund picker and/or portfolio manager?

The challenge with private markets comparisons goes back to the data issue highlighted earlier. It is critical for LPs to use the highest quality, most comprehensive private markets datasets available to them. Hamilton Lane assesses data providers on a few different criteria:

Data quality: does the data provider have the ability to independently verify the figures in its dataset? Can it trace the data points back to financial statements or legal documents?

Data completeness: is the provider able to collect a full slate of data points about each fund? Is the provider able to consistently collect those data points across all the funds it tracks?

Total industry coverage: how much of the total private markets industry does the database track performance data for? Does the database have consistent coverage for different private markets strategies?

Total institutional coverage: some data providers bolster their headline fund count by tracking sub-institutional quality funds – the friends and family venture fund or the $25M buyout fund that only did a few deals. These are funds that most sophisticated LPs would not consider. Does a significant portion of the data provider’s sample consistent of sub-institutional quality funds?

Given a quality dataset, the implementation of private markets comparisons is straightforward. At the fund manager level, performance is usually sliced by the vintage year and the strategy of the fund. In some cases, it can be appropriate to develop a more targeted peer set that includes only the most comparable funds.

The most popular framework for evaluating a manager relative to its peers is to divide the universe of peers into quartiles with rankings determined by a performance metric. In most cases, the performance metric used to determine a fund’s rank is the since inception IRR, though it is also informative to evaluate a fund on TVPI and DPI. Whether a fund ranks in the top quartile (ranks among the top 25% of the peer set) is, in the eyes of many investors, a signifier of whether the fund has been successful.

Source: Cobalt LP

 

Private markets comparisons can also be used to assess the health of the total portfolio. We do not recommend comparing a private markets portfolio to a quartile ranking of funds – this would be akin to comparing a public stock portfolio to the distribution of individual stock returns. Given the wider dispersion of returns among the individual components, this is not a relevant comparison.

Instead, a more appropriate comparison would be to compare the private markets portfolio’s return to a pooled private markets industry return. This would be akin to comparing the performance of a public stock portfolio to the performance of the S&P 500. Comparisons should be run over a variety of time horizons and can be sliced or filtered by strategy and/or geography to either create an industry benchmark that mirrors the constraints of the portfolio; or evaluate the performance of sub-portfolios (i.e., the buyout portion portfolio or the emerging market portion of the portfolio).

Source: Cobalt LP

Other Benchmarking Approaches

Given the imperfect nature of both public market comparisons and private markets comparisons, it is unsurprising that some practitioners have proposed alternate methodologies. Unfortunately, these alternate methodologies often present more challenges than solutions.

Some LPs have considered setting an absolute return hurdle as the benchmark for their private markets portfolios. The thought is that there is some absolute long-run return the portfolio must achieve to justify the risks taken in the portfolio or to fund the liabilities of the LP. The selection of the absolute return hurdle can be arbitrary, is not reflective of the opportunity cost of other investment types, and, since an absolute return hurdle does not fluctuate, will produce large tracking errors. Private markets funds tend to be equity strategies rather than absolute return strategies.

Other LPs have asked whether the shares of publicly listed GPs should be used as a benchmark. Perhaps the share prices of these large, diversified managers can be used as a proxy for the performance of the private markets as whole. After all, if the GP’s funds perform well, it should receive more fees and carried interest, which should raise the share price.

To date, we observe little evidence of a correlation between the performance of private markets and the performance of the share price of listed GPs. The dynamics that influence the share price of listed GPs (management fee revenue, AUM growth, public perception) are independent of the dynamics that influence their underlying private markets investments. Owning a stake in a GP’s management company is ultimately a much different investment than owning a stake in one of its funds.

Conclusion: We end this discussion with a difficult truth: there is no perfect private markets benchmark. There are, however, best practices that LPs can adopt to get a more complete view of the performance of their private markets portfolio.

• Adopt a dual-pronged approach to benchmarking: use both public market comparisons and private markets comparisons. These comparisons serve different purposes. Both are valuable. 
• For public market comparisons, make sure the performance metric used for the public market index is comparable to the performance metric used for the private market portfolio. PME vs. IRR is generally the safest comparison. 
• For private markets comparisons, use the highest quality data available. Quality over quantity. Ask your current data provider how it’s sourcing and verifying its data. Is it collecting the level of detail you need?

Disclosures 

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