March 20, 2013
Interviewed by: David Snow
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Benchmarking Basics: Peer Groups

It’s a tricky but critical categorization to make – against which peer group should a fund manager be benchmarked? And how should investors think about using peer comparisons in selecting GPs to back? This topic is tackled by Michael Elio of ILPA, Andrea Auerbach of Cambridge Associates, and William Chu, Vice President at Zurich Alternative Asset Management. Discussed: Why some GPs are fooling themselves if they think they have no competitors, how some GPs remove “non-core” deals from their track records, and how emerging-markets managers should be benchmarked. This is an important discussion to watch for any GP about to hit the fundraising trail or any LP seeking to improve the way they vet managers.

It’s a tricky but critical categorization to make – against which peer group should a fund manager be benchmarked? And how should investors think about using peer comparisons in selecting GPs to back? This topic is tackled by Michael Elio of ILPA, Andrea Auerbach of Cambridge Associates, and William Chu, Vice President at Zurich Alternative Asset Management. Discussed: Why some GPs are fooling themselves if they think they have no competitors, how some GPs remove “non-core” deals from their track records, and how emerging-markets managers should be benchmarked. This is an important discussion to watch for any GP about to hit the fundraising trail or any LP seeking to improve the way they vet managers.

David Snow, Privcap: Today, we are joined by William Chu of Zurich Alternative Asset Management, Michael Elio of the Institutional Limited Partners Association, and Andrea Auerbach of Cambridge Associates. Hello and welcome to Privcap today. Thanks for joining us. We are talking all about performance of the private equity asset class. Great topic. People want to know more. And luckily, all three of you are experts and have spent a lot of time trying not only to understand it but to make it understandable to people who are in this asset class.

I’d like to talk about an important concept in performance and especially in private equity performance, and that is the concept of the peer group. So there’s your performance, but then there’s your performance relative to other groups that one might appropriately bundle together. There are all kinds of ways you can define peer groups and stick yourself in one or another, and all of you have seen many different methodologies, and I’m interested to hear your analysis and stories.

So a good place to start is maybe setting the stage defining what some of the various peer groups might be and how people might think about it. So Andrea, in your experience, what are some peer groups that people use to define who they are and find appropriate peers against whom to compare themselves?

Andrea Auerbach, Cambridge Associates: Absolutely. There are a lot of different ways to create a peer group for a particular manager that you might be evaluating. And one thing, as I was thinking about the question, I think a very important thing to note is that there are peer groups. There are many managers that will come in to meet with a prospective investor, will meet with us at Cambridge, and we’ll say, well, who do you compete against? And they’ll say, we don’t have any competition. We stand alone. And I think the first thing that we always reference is that of course there are peer groups. Of course there are comparable managers. You could be comparable within the vintage year of the fund that you’re raising, the general size range, or the types of transactions you’re likely to go after, a particular strategy that you might espouse, growth equity distressed, consumer focused, et cetera. So there are a lot of different ways you can group a peer, a comparable, to get a better sense of that manager.

We also at Cambridge Associates do a lot of market landscaping. So for a particular region, we might look at something, or a particular sector or space, to try and get a better sense of where does this particular manager fit into the greater context of things, just so we can compare and contrast. And that teases out a lot of other observations that you might not expect. That’s what we’ve found.

Snow: And of course, peer groups matters because in a certain peer group, there is a benchmark and you can compare yourself against one benchmark or another. So what are some issues that come up as investors are using peer groups, or rather as managers are using peer groups to help investors understand their track record?

Michael Elio, ILPA: Well, there’s the obvious issue of everyone’s top quartile. And you can use your vintage year, your geography, your strategy, you name it, your pre-Lehman investments all as ways to change which benchmark you would be compared to. So effectively in the shopping around for a benchmark, you can change all of those different categories.

Now, the reality is an LP is a little smarter than that, and they don’t just look at what the general partner says their vintage year is, their size, whatever. They’ll do their own benchmarking, their own analysis.

William Chu, Zurich: A couple things that I’ve seen is that like Andrea, these are my non-core investments, these are not something that I’m going to do going forward. I think that that’s one of the challenges as well. How much you weight that? Do you take that at face value? And if not, how do you go about deconstructing that? And of course, then you’re by default then creating somewhat of a synthetic portfolio.

What we’ve also seen is that because of some of the shake out that we’re starting to see and we will continue to see in terms of personnel, those are the bad partners’ deals. We’ve, of course, eliminated that situation and as a result, we should not be beholden to that particular track record, even though last time I checked, there’s an investment committee. Everybody votes. And so those pose, in particular, challenges, I think, to LPs when they’re thinking about peer groups.

Auerbach: And it’s interesting you mention that because I think the other difficulty with peer groups, or peer grouping, if that’s a word, would be they change over time. So the peer group that’s in place at the time at which we’re arriving at an investment decision for our clients as you would, you feel like you’ve got that particular manager anchored in a set that you feel is appropriate. As that investment period gets underway, as people come and go and get promoted, and one deal might be successful which leads to another deal, the peer group may be shifting over time.

So by the end of the investment period, you may be tacking that manager to a completely different set of comparable managers than when you started. And that really adds a level of complexity that we don’t see in other investment strategies, I would say.

Snow: Well, maybe if you could share with us, what are some peer groups that are somewhat useful that all of you use? And then what are some peer groups, or ways of creating peer groups, that you just don’t find are very useful and unfortunately are more often used by, let’s say, GPs to play games with their portfolio? Maybe any stories to share about, again, useful ways to look at benchmarks, and maybe less useful?

Chu: Well, one thing I thought was helpful is obviously, we get inundated with data upon data upon data. I think what GPs often tend to show is equity check. This is how you should consider us. We’re going to write checks of $50 million to $150 million, or what have you. And that’s how they’re going about thinking, this is my peer audience.

The reality is, I think also to set forth, is to understand what size of companies are they going after? What’s the target enterprise value? So I think that’s one metric. Of course, vintage is another way to think about it. Do they lead transaction? Of course, everyone’s a lead, but what does lead really mean at the end of the day? I think as we look at peer groups and particularly in 2006, 2007, 2008 time period where there was a consortium of parties involved in a particular transaction, to really deconstruct and distill down, whose role was a lead, true lead, and whose role was a follower? I think those are truly some of the more challenging type of situations in this time.

Elio: I was going to say one thing that general partners really should do is know that limited partners are really looking at these funds in multiple ways, just as William said. And presenting information, they should just be upfront about it. The general partner that says, well, this is where we are and this is why is the manager that you want to invest in in good times and bad because they call you and they call it out. I mean, I can’t tell you how many times we’ve been in meetings– you can confirm this one– where net IRR is not even on the page. All the benchmarks are net IRRs. That’s what you use. I’m going to ask for it anyway, so you might as well put it on the slide.

Auerbach: As Mike was saying, they all come in and they say they’re top quartile by one benchmark or another. Cambridge Associates creates benchmarks. It’s part of what we do. And I can tell you only 25% of you are in the top quartile. So we always have that conversation.

And I think the other thing that we’ve seen in terms of trying to create these peer groups is you have managers that come and there’s actual. There’s a lot of data that we now have available to us as institutional investors. However, it’s all backwards looking. And I think part of the art of really understanding private equity on a go forward basis is finding that regression line and trajectory through whatever they’ve said and done towards where you think that your blind pool investment is going to be deployed.

And that takes a lot of frequent communication once a fund is underway to make sure that whatever peer group you’ve put them in, they’re staying the course according to what they’ve told you. And so hiding your net IRR and not putting it on the page is not a good signal that that is likely to continue.

Snow: I want to talk about, let’s say, the emerging markets as a case study. I mean, isn’t it appropriate to consider whole segments of private equity to be a bit unto themselves because you want to make sure that you are allocated to, let’s say, emerging markets, or energy, or pick some very big sector, but that group of available managers does have a different performance history than overall private equity? So what is wrong with someone from Vietnam saying, I’m in the top quartile of East Asian, or Vietnamese, or emerging markets managers, even if it’s a very different placement that they would have gotten in the overall Cambridge universe of funds. Is that appropriate, and what would you think about a person who took that approach?

Elio: It is the right approach if you’re only looking at managers in Vietnam. The reality is you may be looking at managers in Vietnam and comparing them to Brazil, or Eastern Europe, or somewhere else. So most folks have a global allocation to certain areas. They’re not bucket fillers. So they’re not going to put money in Vietnam just because he’s the top in Vietnam. He may not meet the threshold of the rest of the plan or the rest of the profile that they have for investing in certain markets. So there are a lot more options than just looking at it that way. And this goes back to comparing them to different peer groups and summing all the analysis together.

Auerbach: Managers, regardless of their geographic location and strategy, can be cross-compared and tack into multiple peer groups. So even if you’re the best for Vietnamese growth equity, we would back you up and compare you to Asian growth equity, emerging Asian growth equity, global growth equity, single country. If they only do tech growth equity, let’s look at them against that.

The other thing with certain emerging markets is you can see the evolution of the

private equity industry through the types of industries that they’re solely investing their way through, and we often use that as a bit of a benchmark for where are they in their growth as an individual private equity market? So there’s multiple peer grouping that goes on for emerging markets managers across the globe that we apply, and I know my colleagues do too.

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