A Different Way to Evaluate Private Equity Performance

An approach tailored to investor risk appetite and more comparable to stocks

The “private” in private equity makes it difficult for investors to fully understand the potential risks and rewards of these investments.

Despite the hazards of illiquid investments and a lack of transparency in financial reporting, an estimated $5.3 trillion in assets under management was invested in these funds at the end of 2021. This is more than the estimated $3.63 trillion controlled by the hedge fund industry during the same period. And the industry is only expected to grow, with predictions that AUM will soar to over $11.12 trillion by 2026. That’s a lot of cash at work buying and revamping companies with the ultimate goal of selling them at a profit.

It can take several years to restructure and sell a company, so investment returns do not come in neat, regular intervals. Also, the valuations of the investments before they are sold are often stale and potentially biased. A common method used by the industry to determine performance is to discount an investment’s cash flows to calculate its return. A simplified example is a $1 million investment at the beginning of the year that returns $1.2 million at the end of the year. The end of year cash flow can be discounted back to its original $1 million investment with a discount rate of 20% and this rate represents the performance on the original investment.

High Returns: Smart Risk Taking or Savvy Deal Making?

However, a high return for a private equity investment may be the result of extreme risk-taking — or merely favorable market conditions — rather than savvy deal making, so investors still need metrics to evaluate fund manager performance. The equity markets evaluate their returns in units of risk for just this reason. Equity returns are broken down into the expected return (compensation for an investment’s level of risk) and the alpha (the return exceeding what was expected, given the risk).

In a working paper, USC’s Arthur Korteweg and UCLA Anderson’s Stavros Panageas and Anand Systla, a Ph.D. student, propose a method to evaluate the performance of private equity investments. Their approach seeks to extend existing metrics by providing risk-adjusted returns that are specific to an investor (such as a pension fund) and its particular risk preferences.

The paper suggests that the authors’ methodology can break an investor’s private equity return into a risk-based expected return and an alpha, equivalent to the metrics used by publicly traded equity investors. Additionally, diagnostics are proposed to determine if an investor could benefit from placing a larger, or smaller, portion of its portfolio in private equity.

Tailor-made metrics

The researchers’ approach does not rely on the valuations provided by private equity funds. Instead, they use the return from an investor’s overall portfolio — including their alternative assets and publicly traded investments — as the rate to discount the cash flows of a private equity investment. This calculates a return for the investment that is specific to the investor’s risk tolerance since their overall portfolio return is a reflection of their risk appetite.

Two metrics for the evaluation of private equity performance are created. Both metrics discount private-equity fund cash flows with an investor’s own portfolio return and both measures can determine the alpha of an investment:

Investor Portfolio Equivalent: When the IPE metric has a positive value, it indicates that an investor could increase the growth rate of its portfolio by increasing the allocation to private equity. However, the IPE could be positive even if the private equity fund’s return could be largely “synthesized” by existing publicly traded investments, which are more liquid and don’t result in fees. This is particularly likely to happen if the investor is risk averse, in which case even an investment in public equities could raise the anticipated growth rate of the investor’s portfolio.

Generalized Investor Portfolio Equivalent: Korteweg, Panageas and Systla address the problem with the GIPE metric to account for an investor’s specific risk aversion. The GIPE measure uses an appropriately scaled version of the investor’s portfolio to determine the discount rate to use. The GIPE allows a direct measurement of outperformance. If a private equity investment can be roughly replicated with some portfolio of public equity investments, then its GIPE will be zero. Therefore, a positive GIPE represents a meaningful expansion of the pension plan’s investment opportunity set, above and beyond what public equities offer. A zero (or negative) GIPE indicates that a pension plan would be better off just investing in publicly traded equities.

Uncovering Potential Conflicts of Interest

Using data on U.S. public pension plans and private equity funds from 1995 to 2018, the researchers tested out their methodology. The pension plan data came from the Comprehensive Annual Financial Reports of U.S. defined benefit public pension plans and included 179 state and local pension plans. The private equity data was sourced from Preqin, a company providing investment datasets on alternative assets.

Korteweg, Panageas and Systla focused on the three main private equity strategies in testing: venture capital, buyout and real estate. They calculated the IPE and GIPE metrics for each strategy with the portfolio return of each pension plan.

Notable observations in their work:

• There was a large amount of variance in the IPE and GIPE metrics across the pension plans. This implies that the pension plans had very different returns on their private equity portfolios. This is interesting since publicly traded equity returns of pension plans tend to be highly correlated.
• Overall, average GIPE values were close to zero, which suggests that pension funds allocated an optimal amount — not too much and not too little — of capital to private equity. One exception were buyout strategies, where the GIPE values were generally positive.
• Pension plans invested in private equity funds that had higher than average risk-adjusted performance, but this was due to some pension plans having an advantage when it came to getting access to top-performing private equity funds.
• They also found that underfunded pension plans, and plans that had a larger fraction of state officials and members of the public appointed by a government official, tend to take on more risk. Yet these plans earn lower risk-adjusted returns on their private equity investments.
• When plans invested in private equity funds located in their state, they earned lower risk-adjusted returns even though these funds took on the same level of risk as funds located out of state. 

These findings suggest pension plans may suffer from agency problems when selecting private equity investments.

With the increasing pressure on pension plans to maximize returns while minimizing risk, the researchers’ methodology may be able to help the industry bring transparency and accountability to an of opaque corner of the investment world.