Tracking the index in private equity

Money has three functions: it is a medium exchange; it is a unit of account, used as a yardstick to measure the value of goods and services; and it stores value. Similarly, stock market indexes, such as the S&P 500 or the FTSE 100, have three missions. Firstly, they measure the evolution of stock prices and possibly support forecasts. Secondly, they support benchmarking exercises, as a yardstick to measure the performance of portfolios of listed stocks. Thirdly, thanks to exchange-traded funds (ETF), they provide an opportunity to economically benefit from the growth of a given economy. By investing in the companies sampled by the index, investors expect to cheaply replicate this relatively unbiased and passive instrument.

What is the equivalent of an index in private equity? This question has attracted a lot of attention and generated significant academic and practical debates. A natural contender would be a stock market index of listed private equity structures. However, this effort has proven inconclusive: listed private equity indexes exhibit a very high correlation with global stock market indexes, essentially tracking open-ended structures which usually blend investment (the equivalent of a fund) and management (the equivalent of the fund manager, or general partner) activities. Listed private equity indexes are in essence indexes of listed equivalents of merchant banks. The reality of private equity investing is of “pure” closed-end funds with a low to medium correlation with listed equity markets (ranging from 0.11 for European venture capital to 0.54 for US LBO).

To measure the evolution of PE performance, high quality benchmarks such as those offered by Pevara are available. Though there is a recurring debate about the use of internal rates of returns, multiples of investments and other instruments as performance measurement, the quality, quantity and diversity of data provides analysts with enough elements to forge an informed opinion. These benchmarks can be used to document past performance and generate very detailed capital market assumptions to support an asset allocation. This exercise can prove difficult when integrating relative levels of risks and liquidity associated with private equity in this asset allocation. Finally, PE performance benchmarks are not investable through the equivalent of an ETF. How to solve the private equity index puzzle?

Table 1 – Benchmark performance ratios of primary funds of funds