Landmark: High IRRs not synonymous with alpha

Interim values and returns data are “unreliable and unnecessary” to evaluate whether a fund manager is producing alpha, according to Landmark Partners.

The secondaries firm recently distributed a white paper to investors that argues a fund’s (or portfolio of interests’) ability to produce alpha can only properly be evaluated by constructing public market benchmarks that consider industry, geography, size and leverage. Cashflow and terminal value are the key indicators, it said.

“Very often one will see a private equity internal rate of return compared with a public equity periodic return, even though these aren’t directly commensurate,” the paper observes. “As a result, very few investors actually know how their private equity portfolio is performing compared to their public equity, or what their optimal asset allocation should be.”

A fund produces “alpha”, one of five statistical measurements used in modern portfolio theory, if its returns exceeded its risk and the investment outperformed benchmarks, while beta refers to performance relative to the broader market.

Alpha is an elusive prey – it grows and shrinks, moves between markets and regions – and some limited partners appear to be more adept alpha hunters than others. Landmark Partners

Many limited partners evaluate managers based on IRRs of past funds, comparing them with funds of similar strategies, geographies or vintages. “But this level of due diligence is an extremely blunt instrument”, the paper argues, noting that many LPs fail to take into account whether a fund has outperformed in relation to peers with similar industry concentrations and leverage levels.

“As a result, some investors think they’re committing to an ‘outperforming manager’ and buying alpha – but often they’re really making a levered beta bet on some industry, possibly investing in a negative alpha-generating manager who just happened to produce a higher, beta-driven IRR than a positive alpha-generating manager operating in a different market or industry.”

Landmark’s paper notes that the private equity asset class taken in aggregate and net fees and carry “does not have any appreciable amount of alpha” but acknowledges studies showing some managers are able to produce alpha and certain LPs, particularly endowments and foundations, are more skilled than others in selecting them. “Alpha is an elusive prey – it grows and shrinks, moves between markets and regions – and some limited partners appear to be more adept alpha hunters than others.”

The paper, written by Landmark partners Ian Charles and Barry Griffiths, also suggests an algorithm for LPs to better assess alpha in their portfolios.