For as long as the private equity industry has been in existence, Limited Partners (LPs) have relied on benchmarks to help them evaluate the performance of their investments. However, while such practices are imperative for making accurate investment and divestment decisions, there has always been a gap in the LP tool-kit when it comes to benchmarking certain groups of funds.
Historically, no precise benchmark has been available to evaluate the performance of private equity portfolios or funds of funds. This means LPs are unable to assess the performance of these investments accurately.
Currently, LPs are limited to comparing a fund of funds investment to a pool of fund of funds even though their composition may be entirely different. Despite being inherently flawed, this type of analysis, known as peer group benchmarking, is widely utilized. This equates to pitting two athletes against each other in the 100 meters but insisting one run at sea level and the other at altitude. Such competition would be unfair and the race result would not be an accurate reflection of the runners’ abilities.
LPs face the same problems when using imprecise benchmarks to evaluate fund of funds investments as current methods do not take into account the distinct geographies, vintages or strategies of these funds.
Consequently, comparisons made with current tools are not truly accurate. At best this results in information and analysis that is a far cry from that which is needed in 2012’s challenging private equity market. At worst the comparison is completely invalid.
The problems with using inaccurate benchmarks have been brought to the fore as an increasing number of LPs allocate more of their portfolios to private equity to generate returns unattainable with other asset classes. At the same time transparency demands from investment committees are putting pressure on LPs to provide more information on the rationale and results of investment decisions. While the situation has never been palatable, the need for change has become more pressing.
The practice of peer group benchmarking throws into doubt the reliability of decisions. LPs 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.
While this might not have been a primary concern during the boom years of the early and mid 2000s, the luxury of making decisions based on imprecise information is no longer acceptable as stakeholders demand exposure to top performing funds in light of shrinking returns. LPs must make operational improvements to ensure the funds to which they commit capital, and the subsequent analysis of those funds, is supported by relevant information.
The need for improved operational processes within limited partner organizations has been exacerbated as stakeholders demand greater transparency. Regulatory requirements, increasingly nervous investors and challenging macroeconomic conditions are all forcing additional scrutiny over capital invested and demands for transparent and reliable performance analysis have soared since the financial crisis in 2008.
It is clear that firms need the ability to track and analyze fund of funds performance more accurately. A change of approach is required.
Firms must look for ways to truly compare like with like, rather than relying on generic, broad-based comparisons. However, to close this longstanding benchmarking gap, a new tool-kit enhancing the capture, manipulation and analysis of data is a necessity.
Custom-weighted benchmarks that mirror the allocation of multiple strategies, regions and vintages found in a specific fund or portfolio are required if optimal investment decisions and analysis are to be delivered. Generating comparisons that are relevant will enable LPs to evaluate their existing investments accurately, mitigate the risk of selecting poor performing funds and meet demands for transparency. This requires access to cash flow data which can be costly if procured on a fund by fund basis. The alternative is to outsource the acquisition, cleansing and validation of cash flow data which can free up limited internal resource to focus on value-add and revenue generating aspects of business.