In private equity (PE), there are more ways to calculate the alpha of a portfolio or fund than in another asset class. And in no other sector than the private markets does investing in the typical fund appear to be doing so poorly.
Should this be so? Is the typical private market fund a foul fund and the typical private market return a foul return? And if that’s the case, why?
In another asset class, the typical fund is one which hits its minimum threshold. So the typical fund isn’t “exceptional”. However, outperforming an index or beta reference on a rolling basis across the main investment horizons is definitely no easy task.
Some time ago I wrote about Private Capital Beta And internal rate of return (IRR)-alpha however the Alpha story still hasn’t modified. What is the rationale for PE Beta’s bad repute? The undeniable influence of David Swensen and the Yale Endowment Model is an important factor.
A 2013 Yale financial report incorporates the blueprint for the Private Equity Alpha Run:
“Yale has never viewed the average return of alternative investments as particularly attractive. The attractiveness of alternative investments lies in the ability to generate top quartile or top decile returns. As long as individual managers exhibit significant dispersion of returns and high-quality mutual funds significantly outperform their less-qualified counterparts, Yale has the opportunity to generate attractive returns for the endowment and demonstrate that manager alpha (excess return) is alive and well.”
So the alpha narrative is about picking winners, possibly those in the best deciles, assuming a large dispersion of returns. It’s a pity that PE quartiles are meaningless and that dispersion is exacerbated by the implicit reinvestment assumption of IRR on which these concepts are based.
The Alpha Syndrome of the Private Market
Marketing all the time focuses on above-average returns and the alpha generated by GPs. This is well-known and simply neglected. But what concerning the alpha gained by allocators, limited partners (LPs) and their advisors?
Much of the blame lies with human nature and a mix of emotional biases and cognitive errors that may influence the behavior and decisions of monetary market participants.
There could also be a necessity to contemplate the pre- and post-investment requirements of investors and shareholders and their behavioral tendencies, equivalent to anchoring effects, regret aversion and illusion of control, which lie behind the event of multiple alpha measures for personal market investments by asset allocators and advisors.
Stakeholders demand security and assurance, especially with regard to often expensive and hardly reversible investment decisions in long-term, illiquid assets. Alpha, as the final word seal of outperformance, should meet this need.
Lack of personal market beta results in alpha-flation
The fact is that the varied measures of personal market alpha don’t only definition of alpha This should apply to financial investments: the surplus return of the particular investment in comparison with the relevant representative benchmark. In the case of PE, this implies an accurate private market beta.
Because there have been no accurate and representative benchmarks for personal market investing, investors, advisors and academics have developed other alpha-like metrics. Most of those are based on public market beta or, in some cases, completely unrelated market metrics.
The direct alpha method is the first measure of outperformance of “financial alpha” within the private market. It is usually related to the KS-PME and has recently been complemented by the surplus value method. The direct alpha method provides a rate of outperformance over a listed benchmark, while the KS-PME provides a ratio and the surplus value method provides the associated monetary amounts. The KS-PME was actually introduced to fill a few of the gaps left by its predecessors. Nevertheless, all of those metrics share the identical inherent limitation: they’re business-specific, so their results can’t be properly generalized. Without this condition, they can not be considered proper benchmarks and their alpha definition isn’t accurate.
Academics and data providers have proposed other metrics to measure P/E alpha, but these have neither overcome the generalization limitations nor achieved the needed one-to-one correspondence between the actual monetary amounts and the compound interest generated by the algorithms.
More recently, practitioners have shifted the alpha focus to the probability of exceeding required investment returns. Given absolutely the return nature of PE, that is an interesting and coherent approach. Nevertheless, it’s more like an emergency exit than an answer to the alpha puzzle.
Overall, these definitional shifts pose a risk for those involved that investors will develop self-referential benchmarking tools that don’t bring the needed objectivity to the investment and reporting process.
What PE Alpha in private equity must be and what it needs
As with other asset classes, PE Alpha should measure outperformance, as Burton G. Malkiel does in Malkiel explained: “A blindfolded monkey throwing darts at the financial pages of a newspaper could select a portfolio that would perform just as well as one carefully selected by experts.”
That is, positive alpha is achieved when a discretionary allocation within the private markets beats a rules-based diversified allocation in a coherent cluster, over a coherent timeframe, on a completely diluted basis and under arbitrage conditions.
This calculation could be achieved using robust and representative private market benchmark indices which might be time-weighted and will give you the chance to offer a one-to-one correspondence to the actual money and net asset values of the underlying fund portfolio through compounding.
This is one among the first purposes of the Duration-adjusted Return on Capital (DaRC) methodology, which is a critical constructing block for appropriate PE benchmarks. DaRC and related indices allow users to find out appropriate alpha and leverage the characteristics of personal market beta and market risk profile in private market investing.
The average private equity fund isn’t a foul fund, in line with our evaluation, and the typical return has not been bad over the 25 years we now have tracked. In fact, we now have found that even fund underperformance could be explained by the relevant private market vintage index (i.e., the typical fund). Investing in blind pools is difficult, and the robust statistics provided by indexed diversification may help.
The alpha-flation of the private market narrative introduces significant distortions. It creates outperformance expectations that misrepresent the overall return management form of private market investing. This could have unintended “boomerang” consequences for the industry, especially now that less sophisticated retail investors are gaining greater access to this asset class.
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