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1 May 2013 CFA Institute Journal Review

Are Too Many Private Equity Funds Top Quartile? (Digest Summary)

  1. Sridhar Balakrishna

The process of benchmarking private equity performance data is fraught with biases and is subject to the availability of accurate and standardized information. The authors discuss the complexity involved in and inherent challenges of measuring private equity performance.

What’s Inside?

The authors identify a problem surrounding the certainty of private equity performance data and the lack of standardized practice, which results in more than the top 25% of funds claiming top-quartile performance. They suggest that a fund being in the top quartile relative to other funds does not ensure that the fund will fare better than other investment vehicles, such as publicly listed securities. Of particular interest to the investment community is their analysis of why benchmarks vary and how such factors as geography and currency can also make a significant difference.

How Is This Article Useful to Practitioners?

Within the alternative investments arena and specifically within the private equity investment segment, investors tend to focus on funds whose performance is top quartile within a particular vintage year. Existing research supports the theory that funds raised by the best-performing general partners (GPs) tend to outperform their peers, beating most mutual funds and hedge funds. Generally, there is limited concern regarding the practices and sources used to compute performance data.

The authors discuss such conceptual aspects as vintage year, challenges of fund classification within the broader spectrum of private equity, availability of data, and performance measures. In addition, they critique the data provided by Preqin, Thomson Reuters VentureXpert, Cambridge Associates, and others. The main challenge for investors in this area is sourcing a dataset that is devoid of survivorship and/or backfill bias.

In addition, the authors identify the reason benchmarks are “moving targets” with regard to meeting specific fund performance needs. Illiquid and hard-to-value assets coupled with the stage of investment (e.g., early-stage venture capital investment and buyout of mature businesses to liquidate through IPO at a later stage) create a challenging terrain for most investors.

How Did the Authors Conduct This Research?

The authors limit their performance analysis to two broad fund categories—venture capital and buyout—that contribute to the vast majority of private equity transactions. Availability of fund performance data is largely limited to the extent of disclosure by private equity firms (GPs) and the sourcing capability of the three prominent data providers. The most commonly used performance measures are internal rate of return (IRR) and money multiples. The median IRRs across each of the data providers are considered for this analysis.

Of particular note is the analysis of performance data with the data provided by the three main sources already mentioned, over a 15-year period (1992–2007). This analysis includes a thorough breakdown of the benefits and limitations of the performance data provided by the three data providers. Finally, the authors compare the performance of two specific private equity funds—Apollo and Bain Capital—and suggest that some of the funds of various vintages originated by these firms have the potential to resort to creative use of data to showcase their performance.

The inherent limitation of private equity data is that they are subject to disclosure of information, lack of timeliness (information usually lags availability by three to four years), and creativity of presenting information by GPs. Furthermore, selective horizon picking and use of valuation metrics that do not exhibit consistency over time create ambiguity for investors.

Abstractor’s Viewpoint

It is essential for investors to customize the benchmark that they intend to compare with specific fund subcategories to measure fund performance. This benchmark should consider vintage year, industry, geographic focus, and performance of similar publicly listed funds and avoid backfilling performance data. Additionally, a comparison of performance with that of a broader range of publicly listed securities (e.g., S&P 500 Index in the United States) for which information is easily available and comparable would be beneficial to investors.

To put this research in context, the interest in private equity investments declined with the onset of the global financial crisis in late 2007. This situation was exacerbated by the decline in the financial markets and lack of exit opportunities for funds that typically have a seven- to eight-year lifespan. Another key factor that inhibits the level of investment within buyout and venture capital funds is their inherent illiquidity.

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