Industry Still Awaits Indisputable Benchmarks

Benchmarking returns in private equity continues to be a challenge for both investors and general partners, and there don’t appear to be any easy answers.

“From our vantage, the current state of commercially available information about private equity is a mess,” wrote the authors of “Inside Private Equity,” a book published last year that focuses largely on the subject of how to measure private equity returns. “We are acutely aware that universe data about private equity is rightly hard to get, assemble, maintain, and audit. We believe that the industry is currently poorly served, and we are not alone in our criticism.”

Such criticism is difficult to dismiss when you consider the source. Two of the authors are Austin M. Long III, head of consulting firm Alignment Capital and before that the long-time head of the private investment group at University of Texas Investment Management Company; and Craig J. Nickels, director of private markets at Washington University. Back in the early 1990s, Long and Nickels developed a method for comparing private equity and public equity returns that is still widely used, including by Thomson Reuters in its annual investment benchmarking reports. (Thomson Reuters is also the publisher of Buyouts.)

The authors believe part of the problem has to do with data providers such as Cambridge Associates LLC and Thomson Reuters not having access to enough data. In the year-end report on its “U.S. Private Equity Index,” Cambridge Associates said that its pooled return numbers are derived from 815 U.S. private equity funds formed between 1986 and 2009. For its year-end numbers, Thomson Reuters said it had a sample size of 725 U.S. buyout funds—not all of them active contributors—out of a universe of 1,888 formed from 1969 to 2009. (In an email, a Cambridge Associates spokesman wrote that the firm “constantly seeks to add institutional quality managers to our database and benchmark, both through the hundreds of manager meetings held each year by our consultants and through the addition of new clients’ portfolios.” Thomson Reuters recently teamed up with Hamilton Lane Advisors in a joint effort to boost the number of funds in its sample.)

The authors seem to delight in pointing out the big difference between the 10-year venture capital pooled IRRs published in the first quarter of 2008 by the two firms—32.83 percent by Cambridge Associates and 17.20 percent by Thomson Reuters. “Are these two firms measuring the same thing?” they wrote. “Who would know? There are obvious culprits including timing of cash flows, participation or lack thereof, survivorship bias, and just bad data.”

It happens that the latest figures are much closer. The Cambridge Associates 10-year pooled net return to limited partners for venture capital as of year-end was -0.92 percent; the comparable Thomson Reuters pooled IRR figure is 1.1 percent. One possible explanation for the discrepancy, then and now, is that the Thomson Reuters database includes the 1969 to 1980 vintage-year funds not included in the Cambridge Associates numbers.

Still, the perception of a wide gap persists, and the fact remains that the industry has yet to fully embrace one set of private equity indeces as utterly reliable and trustworthy. And the implications of that being so are significant. Erik R. Hirsch, chief investment officer of Hamilton Lane, said in a recent interview: “We really see this as an impediment to the asset class growing.” Among the reasons:

• Without unquestionable benchmarks to point to, boards of institutional investors may feel they don’t have the information they need to determine whether private equity is a good asset class to be in;

• Even if those same boards believe the asset class to be worthwhile, they may question how they can compare the performance of their staffs and advisers with the rest of the industry;

• Less-than-scrupulous general partners have found ways to call themselves upper-quartile in part by rolling out the most favorable benchmarking numbers they can find. The result has been fund managers getting backing that don’t deserve it, depleting dollars for more worthy fund managers and dragging down overall industry returns.

Indeed, it’s become a running joke in the industry that you never run into a firm that doesn’t claim to be an upper-quartile performer. I can’t prove it statistically, but my guess is there’s a direct correlation between overall industry returns and how funny limited partners find that joke; the lower the returns have fallen, the less funny.

Then again, can anyone definitely say whether industry returns have headed lower or not?