October 14, 2014
Interviewed by: David Snow
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Beating the S&P 500: Should It Matter?

Should investors use public benchmarks like the S&P 500 to gauge the performance of their private equity program? If so, what should the target outperformance be? What about sub-sectors within private equity? Three experts weigh in.

Should investors use public benchmarks like the S&P 500 to gauge the performance of their private equity program? If so, what should the target outperformance be? What about sub-sectors within private equity? Three experts weigh in.

Beating the S&P 500: Should it Matter?
Private Equity Performance

David Snow, Privcap: Today, we’re joined by Andrea Auerbach of Cambridge Associates, Erick Bronner of the Riverside Company, and John Clark of Performance Equity Management. Welcome everyone to Privcap. Thanks for being here.

Our topic is private equity performance. It’s a very important topic and I’d like to ask you a question about benchmarking. If you invest in an asset class, you have to measure how you’re doing and you often measure against some benchmark. In the private equity world, many investors benchmark against some public market index, plus some markup from that. We’re going to talk about whether that’s a good idea and what is the right way to do it. Erick, as an IR professional you’re in touch with many investors around the world. How prevalent is the practice of using a public market index as the benchmark for private equity?

Erick Bronner, The Riverside Company: Conceptually, investors come and they expect that the private equity fund manager is going to outperform at a baseline of public equity index because it’s an illiquid security, it’s long-lived, and getting out of it is more difficult than a public security. So, there’s an expectation that you’re going to exceed some public market index that they deem similar to your strategy by some number of basis points. However, that’s a base case assumption. As you get into why they make the investment, it becomes a relative measure. How well they do as a private equity fund manager versus whatever is deemed to be your peer group and the target as being in the top quartile, however that is defined for your peer group. At a base case, they expect that you as a private equity professional are going to beat the public markets. But when it comes down to an individual fund decision, they tend to view you on a more relative basis.

Snow: John, what’s your experience as someone who also works with many institutional investors?

John Clark, Performance Equity Management: Benchmarking obviously is a critical part of evaluating your performance and beating the public alternative, if you want to call it that. That’s a mission statement of most private equity firms, so you do measure yourself to that. When I joined a predecessor firm in the mid-90s, it was much more archaic and we had a benchmark for our bonus that was a spread to the theoretical long-term return of the S&P. The idea was right, but with some of the new developments in benchmarking around PME and so forth, it is a relevant tool. As Erick mentioned, at the end of the day, you still need to be looked at favorably to your peers because, in the buyout universe, there are a ton of small mid-market managers focused on healthcare, industrial and energy, and you’re going to benchmark against those folks as well. It’s a combination. The tools are there to evaluate a lot of benchmarks. Obviously, you have Cambridge, you have Prequin now, and when you look at how many of those relevant benchmarks are now populated by the number of managers, certainly relative to what you saw in venture economics, it’s all improved. We compare ourselves to the public alternative in benchmarking, and people are going to ask how you have done compared to that.

Snow: Andrea, what is the approach or the suggested approach of Cambridge Associates to building an appropriate benchmark to beat in your overall private equity portfolio?

Andrea Auerbach, Cambridge Associates: I would say, “Do it if it feels good,” but that’s probably not appropriate.  We’ve observed that folks are trying out PME. So, you can apply a public market equivalent benchmark in three different tiers in your program. You can apply it at the very top of the program. How are all of my assets doing against a public market benchmark of some kind? Then, you can take it down to the private equity side, which is where we’re talking about, and you can apply it as, “Did I make the right call investing in privates versus publics?” Then you can take it down to the strategy level: “Did I make the right call investing in private equity versus venture capital?” Then, you can take it all the way down to the fund manager level: “Did I make the right call investing in you?”

There are so many different layers to apply a public market benchmark or any benchmark really. With the increased prevalence of the knowledge of PME, what we’re observing is that folks are using it but they’re using it a little off-line. They’re watching how it behaves. And there are a lot of different factors that can influence your PME measurement—it’s not just about IRR. There’s also a multiple that can be created with PME. So, now you’ve got two new factors that you want to introduce into your performance measurement framework. We’re observing that a lot of folks are running it off to the side, watching it, seeing how it behaves during their measurement periods, and trying to understand how this is truly useful for us. We are finding it probably the most broadly applied is in hindsight review: “Did I make the right call taking some capital and putting into the private market versus the public market?” That’s really a backward-looking confirmation or call on that one capital allocation decision, but PME isn’t going to help you going forward.

Bronner: I would add to what Andrea just said. When investors are talking to funds (and obviously at Riverside we have a bunch in the market over the last couple of years), and they’re looking at you specifically, you don’t feel that sense of, “They’re comparing me to a public equity market.” You feel that sense of, “What’s the other collection of private equity funds we feel are in your strategy and what are we doing?” But where you do feel it is in thinking that, as an organization our allocation mix is being colored by that prospect of looking up, where should we put our capital and how has private equity performed versus public equity? So, the total aggregate dollars available for our asset class comes down to, on a relative basis, how well you think private equity has performed versus whatever the deemed appropriate indices are.

Clark: The public universe is so huge that the goal of benchmarking, looking historically, is to find out whether there are lessons you can learn to be a better investor. There some takeaways. People use it in different ways and use it less frequently or more frequently, but why not take advantage of all the tools you have to try to understand your portfolio better? Get to understand the decisions you made. Look at how certain pieces of the portfolio work in certain cycles in the economy and take all that information, even if it is historical. But are there takeaways that can make you a better investor? I think that’s part of the whole dynamic.

Auerbach: What’s interesting about PME versus, say, a private market’s benchmark is that when it’s all lower middle-market managers in the pool together, how’d you do? Let’s take the full measure of you individual manager against your true cohort. One adventure you can have with PME is that there are hundreds of indices you could choose and you also have time and point sensitivity around the period of measurement that you’re going to apply. Especially if you’re doing anything above an individual manager’s fund performance level, you can pretty much start picking. Let’s look at it on a three-year, which I would argue is very inappropriate for private equity, so a five-year or a 10-year. Now, let me flip through the book of different indices that I think might be relevant here and then apply them in an appropriate way. There’s so much more customization that can be pursued with PME that it could make your version of your PME analysis very different from mine, for very acceptable reasons. This has kept people and institutions maybe thinking about it a bit more on the side of, “How am I going to fully incorporate it because we aren’t going to speak the same language on our PME measurement, because you may be making different choices than me?” That might make it a more difficult comparative conversation.

Snow: Final question for anyone and maybe it’s too big a question to even answer, but what is the standard or the accepted spread over a public market index that makes it worth your while to be invested in the private equity asset class? How much better do you need to perform given the headache and time and expense of being in private equity?

Clark: Long term, we’ve always felt that, again, it has to be long term. Not three-year or even five-year. You should beat the public alternative by 400 to 500 BPS. That’s something we’ve been able to do, but when you look at the illiquidity aspect in the portfolio, there are pieces of a private equity portfolio that you’re not going to get access to in the public market as well. Some of those, you may argue, have a beta greater than one. Looking at some of the studies, venture certainly was in the ‘90s. Maybe not so much in the 2000s, but getting access to seed and early-stage through a private equity strategy, you’re getting access to an exposure I couldn’t get in the public market. Even small micro cap, higher growth—there are things you can do in the private equity arena that you can’t get access to in the public. So, that plays into it a bit as well, but to us, the short answer is that you should have at least a 400 to 500-BPS spread. That’s what our target is long term.

Bronner: I’d echo that’s what I’m largely seeing in the marketplace. Again, on a base case when they’re thinking the alternative asset buckets and alpha bucket to begin with, and asking what makes sense in terms of the man and woman power you have to put into evaluating these illiquid securities?  You have to hold them and if they don’t go right, you have to try selling them in a secondary market, and my sense is that those are about the right spreads I’ve been seeing in the marketplace. In the sense of getting exposure to transactions that you wouldn’t also get exposure to is as meaningful in a lot of ways, as that assumption because there are a lot of things you can’t do there.

Snow: I am looking at the Cambridge data for 20-year performance of private equity against the S&P 500 for private equity. The S&P 500, in the last 20 years, is 8.25% IRR. Private equity’s is 13.70 IRR, so according to your suggested outperformance, private equity’s right there. So, I guess it is worth it—

Clark: It’s a really questionable benchmark you’re using there.

Auerbach: What? May I humbly propose that the illiquidity premium—we do the surveys as well and 300 to 500 over seems to be a bit of a mote, but may I offer that an individual investor’s illiquidity premium can be anything from zero to whatever they think is appropriate? Because if you can afford to have massive illiquidity in your portfolio, then your premium could be quite incremental and you’re just focused on the absolute return, not the relative return. One thing we tend to keep in mind is that each individual institutional investor we work with may have very different capital requirements and constitution to withstand illiquidity. So, to one client they may not consider adding a premium. They just want that absolute return and they’re all in venture, whereas others are more mindful of that due to what they’re expecting to do with their assets; they are looking for more of a clear, relative benchmark to help guide them as their portfolios mature. So, I would just offer that, despite of course, private equity beating the S&P for the long run.

Snow: Go private equity.

Clark: Yes. It’s interesting. When you look at the private equity asset class, there are portions and subsectors within that. So, you expect venture to outperform buyouts and you expect emerging markets to be somewhere in between. Mezzanine debt and distress are going to be a bit lower than that, but we have a direct strategy and we expect our strategy to outperform our partnership investments. Obviously, we’re not paying a carry or fees on those investments and, over the long term, we should get 300, 400 or 500 BPS above our partnership portfolio. So, we measure within the portfolio as well—the relative returns. Why would I do directs if I can’t beat my alternatives, which are partnership investments? It’s interesting because you look at relative spreads within the private equity portfolio as well, and you can measure how you’re doing in each one of those.

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