Setting the benchmark

PE Manager revisits some of the year's best guest articles: In July Gitanjali Swamy of AARM Corporation argued that of all the private equity benchmarks available, none fully satisfy investors’ needs in the GP selection process.

Reliable benchmarks provide a means for analysing the relative performance of individual investments and thus can have a profound impact on investment decisions. That’s why consultants and investment advisors rely on benchmarks for decision making and reporting – and why it’s so crucial that effective, reliable and transparent benchmarks be available.

A proper benchmark should always display four characteristics: transparency and lack of ambiguity; frame-ability/measurability; appropriateness and coverage; and investability. But most indices do not meet the standards of a proper benchmark. This is not surprising in an emerging industry such as private equity. Take, for example, the five following benchmarks: the Cambridge Index, the Preqin Index, the State Street Index, the Global LPE Index; and the AARM FOIA Index.

Cambridge Index
The Cambridge Index is constructed by Cambridge Associates by leveraging its confidential and proprietary nonmarketable alternative assets database. While Cambridge’s Benchmark was one of the first, it does not satisfy most of the criteria for correct benchmark construction. Neither the components nor the price in the Cambridge benchmarks are disclosed. Thus, it fails construction for component and price transparency and un-ambiguity. However Cambridge does disclose the construction methodology and clarifies ambiguity on the correct calculation of financial terms like IRR, multiple, age, etc.

Preqin PE Index
Unlike Cambridge, The Preqin Performance Benchmark offers breakdowns by product (venture,

The [Preqin] benchmark is not frame-able because it is unclear why a fund is or in not in the benchmark

buyout, mezzanine, distressed, special situations, real estate, natural resources; fund-of-funds, secondary) but not by other factors like geography or industry focus. The biggest advantage of the Preqin Benchmark is its transparency in component and in methodology. However, the benchmark is not frame-able because it is unclear why a fund is or in not in the benchmark. The benchmark (like all benchmarks in private equity) is not investible.

State Street Index
The State Street Private Equity Index is based on the latest quarterly statistics from State Street Investment Analytics' Private Edge Group. State Street’s Benchmark provides some measure of coverage by disclosing the total AUM of its clients and the number of clients it supports. While this is not a complete specification, it is far superior to the prior two benchmarks on coverage. However, State Street’s benchmark is neither transparent nor frame-able in components, price or methodology. The State Street Benchmark is not investible either.

The Global LPE Index
The Global LPE Index tracks the performance of private equity firms which are publicly traded on any nationally recognised exchange worldwide. The index is comprised of 40 to 60 public companies representing a means of diversified exposure to private equity firms. The securities of the index are selected and rebalanced quarterly per modified market capitalisation weights. The Global LPE Index is the only PE index that is investible through investment products such as the PSP powershares ETF. Additionally, it is completely transparent in its construction. But it also has serious shortcomings, as it is neither appropriate nor does it have sufficient coverage. There are very fewer than 100 private equity firms/funds that are publicly traded and they in no way represent the majority of the thousands of PE firms/funds that compromise the industry.

The AARM FOIA index is completely transparent and unambiguous on components, price and methodology. The index comprises fund performance data of LPs with the largest portfolios of alternative asset investments. Since fund data is collected from public data sources – websites of the public pension funds and university endowments, AARM limits components to those invested in by LPs that disclose their portfolio performance. The AARM index is also completely transparent and unambiguous in the methodology for construction and lays out rules for aggregation. For example, if multiple LPs invest in the same fund, the average performance statistics for that fund are constructed using simple averaging. The AARM benchmark is weighted by capital commitment and is available by product, industry, and geography and fund size. Like most other PE benchmarks, the AARM benchmark is not investible. However, it is completely appropriate and representative and does have a very high coverage of the space with nearly 6000 funds in its dataset. The index includes a similar number of funds and more data-points than Preqin but it defines quantitative coverage as a percent of all available funds.

In order to achieve the status of benchmark, most existing indices require modification. In the meantime, investors should determine which of the benchmarking characteristics described are most important for their own purposes and seek the most effective, reliable and transparent benchmarks available.

Gitanjali Swamy is head of LP advisory firm Alternative Asset Risk Management. The above article was based off research Swamy conducted with AARM executive vice president Irina Zeltser; University of Massachusetts finance professor Hossein Kazemi; and Edward Szado, a research associate with non-profit research foundation the Institute for Global Asset and Risk Management.