- Argues for critical importance of benchmarking to operations team
- Favors public market equivalent technique, specifically Direct Alpha method
- PME benchmarking now part of Backstop’s portfolio management platform
The title of a recent white paper by Ben Crawford throws down a gauntlet to GPs and LPs: “Every Institutional Operations Team Needs to Be Better at Benchmarking Private Equity Investments.”
“Benchmarking in general is a hard discipline,” said Crawford, senior product manager of performance and quantitative analytics at Backstop Solutions Group, which provides portfolio-monitoring software to the alternative-investment industry. While it can be learned in a matter of months, “it really is kind of art and science. It can take a career to become masterful at it.” And that’s in public markets, where information abounds; in PE, there are “a lot of idiosyncratic features and much less data,” making it that much harder.
Despite the lack of clarity, the subject is too important to be avoided. “It’s not an exaggeration to say that the performance of an investing organization hinges on its Operations team’s facility at benchmarking,” Crawford’s paper argues. That’s because benchmarking provides the means to evaluate decisions in terms of relative risk and reward, which in turn enables a team to confidently separate the wheat from the chaff among managers.
Crawford advocates the Public Market Equivalent technique, which “constructs a hypothetical portfolio that mimics the cash flows in and out and the valuation pattern that you would have with your private equity investment, but assumes that those cash flows occurred instead in this broad market index.” If instead of putting cash into illiquid private investments you had just indexed it, would you be better off, or worse? And to what degree?
This approach, known as the Index Comparison Method, was first presented in a 1996 paper by Austin Long and Craig Nickels. “The idea was well-received, and people were pretty excited about it at first, but it turns out there are a couple of problems,” Crawford explained. If, in a given period, the chosen index does particularly poorly, or the PE investments perform especially well, then the value of the hypothetical portfolio can go negative, creating a net short position and fouling up the analysis.
Attempts to prevent this from happening introduced new complications: You could keep the benchmark value non-negative by scaling transactions up or down, but such heuristic tinkering created numerical bias and lacked any economic basis. So a new framework was proposed, by Steve Kaplan and Antoinette Schoar, which generates a comparative IRR between PE investments and a hypothetical portfolio without any risk of the latter going negative. Backstop prefers to use one such methodology, called Direct Alpha.
Despite the superiority of this approach, recognized by academics, practitioners have been slow to adopt it. Crawford says that will change: “The elegance that’s presented by the Direct Alpha and Kaplan-Schoar method [is] where the industry is going to go over time. As part of the effort to give more tools to our private equity users, we thought that adding this flavor of PME made a lot of sense.”
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Photo of Ben Crawford, senior product manager of performance and quantitative analytics at Backstop Solutions Group, courtesy of the firm.