February 2013

INSIDE VIEW: Wanted: a more precise approach

Measuring tapeWith traditional asset classes unable to achieve secure returns, more and more asset managers are looking to the private equity industry. Paul DiBlasi, of Pevara, reports on justifying investment with new benchmarking techniques. Increasingly, asset managers are looking to the private equity industry to secure returns that can no longer be achieved from traditional asset classes. Pension funds especially are upping allocations to private equity as they struggle to meet their obligations solely by investing in the public markets.
However, stakeholders are demanding quantitative “proof” that justifies this change in investment strategy. Higher fees and concerns around liquidity are causing investment committees and trustees to question whether private equity really can deliver the superior returns that have historically been attributed to the asset class. Add to this ongoing demands for transparency from all corners and it is apparent asset managers need a clear strategy for evaluating the performance of their investments and validating their investment decisions. CHALLENGES
For years, both the public and private markets have relied on benchmarks to evaluate investment performance. It is an essential practice that helps asset managers make accurate investment and divestment decisions. In the more familiar public markets, benchmarking information is readily and instantly available. However, asset managers are quickly learning this is not always the case when it comes to private equity as the benchmarking data available to measure the performance of individual funds is limited.
Measuring the performance of a group of private equity funds – all funds in a portfolio or a fund of funds – presents an even greater challenge.
Previously, asset managers could benchmark the performance of an individual fund in their portfolio but not the performance or exposure of an entire portfolio. Similarly, they lack the data and tools to accurately benchmark their investment in a fund of funds – a collection of funds with different strategies from different vintage years.
This gap in the benchmarking landscape makes it difficult for asset managers to assess the performance of these investments accurately and justify their allocation to private equity.
Asset managers are limited to comparing their funds of funds investments with other funds of funds. For instance, an asset manager may benchmark their investment in Alpha Fund 3 against Beta Fund 4 because they are both 2007 funds. However, if Alpha Fund 3 is made up of venture capital (VC) funds with a European and US focus and Beta Fund 4 consists of buyout and VC funds with a US focus, the comparison is not really valid.
Despite being inherently flawed, this type of analysis, known as peer group benchmarking, is widely utilised in the private equity industry. It equates to pitting two athletes against each other in the 100 metres but insisting one run at sea level and the other at altitude. Such competition would be unfair and the result would not be an accurate reflection of the runners’ abilities.
The practice of peer group benchmarking throws into doubt the reliability and transparency of investment decisions. Private equity investors are acutely aware that the credibility of their current approach to assessing performance is not up to scratch, but they persist as there has been a dearth of other options.
Asset managers are, therefore, looking for more precise ways to evaluate private equity portfolios and fund of funds investments. They need the ability to truly compare like with like, rather than relying on generic, broad-based comparisons; this is the only way to provide the comfort and transparency sought by investment committees, regulators and investors. To achieve this a new tool-kit is needed that enhances the capture, manipulation and analysis of data.
Custom-weighted benchmarks that mirror the allocation of multiple strategies, regions and vintages found in a specific fund or portfolio are required.
Generating comparisons that are relevant will enable asset managers to evaluate their existing investments more accurately and better mitigate the risk of selecting poor performers. This requires access to the cash flow data underlying a benchmark which is difficult to procure and time consuming to compute. The alternative is to outsource the acquisition, cleansing and validation of cash flow data to a specialist. ADDING RIGOUR
Once sourced, the means to weight and aggregate cash flow data in a way that precisely reflects investment strategies is required. Attempting this with standard tools, such as Excel, is a complex and time-intensive process. Automation, in the form of a solution that can generate an exact replica of private equity investments at the push of a button, will deliver significant benefits.
An asset manager that can tailor private equity benchmarks to the precise makeup of a complete portfolio or fund of funds will provide new insight into private equity performance. Customisable benchmarks will enable asset managers to better evaluate performance and add rigour to decision-making processes improving due diligence and equipping firms with the intelligence to uncover top performing investments.
The ability to analyse data more accurately also bolsters transparency and accountability of the investment process.
Ultimately, if asset managers are to instil confidence in increasing allocations to private equity, taking a more precise approach is the only option. Paul DiBlasi is chief operating officer at Pevara ©2012 funds europe

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