More Realistic Performance Benchmark Advanced

Everyone complains about the quality of private equity benchmarking. Now a trio of academics is doing something about it.

One of the biggest challenges for existing benchmarks is adequately capturing volatility in the value of the underlying portfolio companies. Indices that are transaction-based, for example, suffer from a time lag, since they only get updated after realizations.

So-called “appraisal value-based” indices from Thomson Reuters and others are typically updated quarterly. However, even this frequency tends to smooth over bumps and jolts in portfolio-company valuations during the quarters. Like transaction-based indices, they also suffer from a time lag, since it often takes many weeks for general partners to report returns and cash flows to their investors.

Indices based on listed private equity firms, meantime, have a habit of hopping around far more than they would if derived solely from the value of the underlying assets. They can therefore overstate volatility.

“Thus, none of the three index concepts currently in popular use is fully capable of capturing the risk/return profile of PE, and none provides the necessary input quantities for portfolio optimization or risk models,” the three authors of a recent academic paper wrote.

In the paper “Private Equity Benchmarks and Portfolio Optimization,” the authors use mathematics to convert an existing appraisal value-based index updated quarterly to a contemporaneous one updated monthly. If their index more accurately captures the risk-return profile of venture capital and buyout investments, as the authors believe it does, then institutional investors would be better served using the new index to determine their target allocation to the private equity asset class.

“Overall, our results confirm that our new index improves risk management for PE limited partners, thus facilitating the flow of funds into the PE industry.”

The draft paper, dated March 9, is co-written by Douglas Cumming, a professor at the Schulich School Of Business at York University; Lars Helge Haß, senior lecturer at the Lancaster University Management School; and Denis Schweizer, assistant professor at the Otto Beisheim School of Management.

Download a copy of the paper here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2251001&download=yes