Harvesting Alpha from PE Investments in a Highly Valued Marketplace
With record levels of dry powder and continuous rise in deal multiples, the ability of private markets to continue with …
Deciles and quartiles have been around for a long time and have been used to rank everything from hereditary traits to student test scores to crime rates. First seen in 1882 and 1879 respectively, both terms are attributed to Francis Galton (1822-1911), the British mathematician, explorer and cousin to the considerably more famous Charles Darwin.
Among investors in alternative assets, quartile ranking – where funds are split into four performance groups – has long been considered the gold standard for assessing private equity funds by both LPs and GPs. During the past year, however, preferences for performance results have moved away from quartile ranking in favor of more granular decile ranking.
Why the sudden migration toward deciles? Part of the answer lies in the inherent limitations of quartile ranking. To begin with, dividing all of your data among only four quarters can hide a great deal of detail and useful information. For example, if a fund ranks in the second quartile, there’s no way of seeing where it ranks within that quartile. It could be at the bottom end, near the median, or at the top end and, therefore, a better performing fund. Simply put, quartile ranking hides both good and bad variants and can obscure significant differences in performance. And in the current private equity space, so many of the funds are in the top quartile that the label becomes meaningless.
On the other hand, decile ranking, with more than twice the available measurement buckets, is much more likely to reveal those outliers, especially those that would have been at the edges of the quartile buckets. So instead of comparing funds ranked only as not-so-good, pretty good, good and very good, a limited partner can make investment decisions based on quantitatively better information.
However, simply switching to decile rankings is likely to show a disproportionate number of managers in the top 10%-20% of funds. But when you can combine this more granular ranking with a more consistent data collection practices—such as using LP cash flows rather than GP survey results to track return activity and with other differentiators such as geographic and investment stage and size focus—deciles can become a real indicator of performance rather than just another marketing tool.
Despite these drawbacks, quartiles used to be sufficient. More recently, though, LPs have been faced with a new and vastly demanding environment. Consequently, LPs must perform more due diligence and, thus, need performance rankings that show much more granularity. LPs have also become much more sophisticated out of necessity. They want—and need—more transparency and better tools for more precise analyses of alternative investments, where management and performance fees are typically high. Deciles enable LPs to meet these demands.
One reason LPs are more selective is because the number and size of private equity funds has increased significantly since the financial crisis of 2008. Research firm Preqin estimated in late January that there are more than 2,200 private equity funds currently being marketed, an increase from just over 2,000 at the start of 2014 and 1,949 at the beginning of 2013. And 37% of private equity managers polled earlier this year said they planned on launching a new vehicle in 2015.
Since limited partners today have a much larger network of general partners with which to invest, sorting out the performance data of firms and funds is more difficult. A quartile system would still present a burdensome amount of fund data to sift through to find the best performers. Deciles can quickly narrow an LP’s menu to only the best-performing options.
And while the choices available to limited partners have increased, pressure to perform has intensified. Particularly among the larger institutional pension funds, scrutiny of limited partner investments shows no sign of abating. LPs are now being asked to rank and quantify the returns they receive from every investment, particularly when they are paying large fees as they do for private equity funds. LPs need to justify each and every investment down to the last decimal point.
With greater requirements placed on LPs for more detailed and useful rankings, there is a clear need for a universal benchmark that will serve to standardize performance assessments industry-wide.
Adopting deciles as the standard ranking measure is a good start as we continue to develop the standards that will move the private equity industry forward. Ranking fund performance by decile rather than by quartile gives funds the chance to shine their brightest and meet the needs of an ever-more-demanding LP community.