This article originally appeared January 18, 2002 on PrivateEquityCentral.net
Most limited partners would agree that a general partner's compensation should be tied to performance. By contrast, many professionals whose job it is to select superior private equity fund managers do not benefit from the incentive of having their compensation tied to the performance of the funds to which they commit their employer's capital.
At the core of this disparity are benchmarks, or rather, the lack thereof. Charting the performance of a single fund is hard enough - try setting a meaningful standard for the performance of a collection of private equity funds with different strategies and vintage years. And yet, increasingly, institutions are searching for appropriate benchmarks for their private equity portfolio managers to beat. In the process, these institutions are being forced to define exactly what they expect from the asset class.
A consultant who works with pension funds estimates that only 30% of private equity portfolio managers receive bonuses tied to performance. If pensions, endowments and trusts go the way of the rest of the institutional investment world, this number will increase. But along the way, people trying to structure incentive programs are coming across roadblocks unique to the private equity asset class.
Selecting private equity funds, of course, is not like selecting stocks. Rather, the process of vetting, committing to and then tracking limited partnerships is like stock-picking in slow motion. A stock's value might be, say, 50% higher 12 months after being purchased, thereby making its performance easy to chart. By contrast, the true value of a private equity partnership cannot be known for years. Because of this, creating a year-to-year incentive program for professionals who pick limited partnerships is a daunting task, and one that has historically prevented institutions from creating incentive programs for private equity portfolio managers. Complicating matters further is the fact that many, if not most, portfolio managers responsible for committing to a group of funds in a given year are not at the same institution by the time the funds are fully exited 10 to 15 years later. Similarly, with turnover at institutional investors as high as it is, a portfolio manager enjoying a year of big cash distributions cannot always claim the successes are related to decisions he or she personally made.
The inherent problems of private equity benchmarking present a conundrum to institutional investors, who are eager to ensure that their portfolio managers are not incentivized to select a G.P. group just because they sprang for dinner at Le Bernardin. Investing institutions, like pensions and non-profit endowments, are also finding it increasingly difficult to retain talented investment professionals, who, lacking performance incentives, are easily lured to funds-of-funds and other groups where they can share in the upside of the underlying partnerships.
"We're seeing an evolution at large institutions," says a consultant who advises institutional investors on their private equity programs. "It's a huge issue that didn't exist a few years ago. There's so much money committed to private equity now that the returns in the asset class are actually making an impact on the overall returns of the pension or endowment. This has given the managers leverage. They say, 'I'm making a difference now.'"
The decisions of private equity portfolio managers have certainly made a difference at investing institutions, but those institutions are having a hard time determining whether that difference has been below, in line with, or above expectations. Put bluntly, if the venture capital portfolio at a state pension has returned an average of 40% per year for the past decade, that's fine, but the investment committee wants to know whether they would have done better had they simply let an orangutan sort through the PPMs.
That's where benchmarks come in handy. Benchmarks are used widely by managers of liquid securities, like stocks and bonds, but infrequently by private equity programs. And while indices like the S&P 500 are familiar to all, there exists no industry-standard benchmark in private equity. "Most people on investment committees are very savvy when it comes to public markets," the consultant says. "They know if the right benchmark should be the Russell 2000 or the Dow. But with private equity, they don't know much."
Venture Economics, for one, believes demand will continue to grow for benchmarking services in private equity. The New Jersey-based private equity data services company creates a range of benchmarks, some based on average IRRs and others on "realization ratios," which chart how many dollars are returned for each dollar invested. (G.P.s love these ratios, because they are impervious to time, as in, "One dollar out, $3 back. Never mind that it took 15 years!")
One especially appropriate benchmark for L.P. performance, according to Jesse Reyes, vice president of global product management at Venture Economics, is the composite pooled IRR by vintage year. These benchmarks assume a scenario in which an investor puts the same amount of money in all private equity funds raised in a given year (the benchmarks are also available for specific investment strategies, i.e. early stage venture capital, buyouts, etc.) For example, the Venture Economics private equity vintage year 1995 composite pooled net IRR (phew!), is 16.8%. In other words, Reyes says, a perfectly "nave" portfolio manager with a broad private equity mandate should hit 16.8% on his or her vintage 1995 portfolio. Anything above that number, one hopes, represents a skill for picking winners. Anything below it may represent too much time spent at Le Bernardin.
Institutional investors will certainly want to see that their private equity portfolio managers are beating "nave manager" benchmarks, but they have an added requirement - considering all the trouble it takes to invest in the private equity asset class, it had better outperform the stock market, otherwise, why bother? A private equity portfolio has the double burden of needing to outperform other similar portfolios, as well as needing to outperform other asset classes, commensurate with the risk assumed in the program.
For this reason, Venture Economics finds itself competing with the likes of Standard & Poor's as a provider of private equity benchmarking services. The most common performance benchmark for private equity portfolio managers, it turns out, is, as one consultant puts it, "S&P 500 plus a few percentage points." How many extra percentage points are added to this stock-market benchmark depends on how high an institution's expectations are for the private equity asset class.
Increasingly, however, institutions are creating more sophisticated ways to judge private equity performance by mixing indexes and benchmarks from both public and private markets. Most of these benchmarks have to be custom-built. Steven Millner, a managing partner at DML, an accounting services firm that serves the private equity industry, says his firm recently completed a benchmarking study for a major bank. "The end product was a composite benchmark, aggregated by sector, and then compared against of bunch of indices, including the S&P 500," Millner says. "When it comes to benchmarking private equity, there's no one way to look at it."
In at least one respect, says Jeffrey Ennis, a managing director at funds-of-funds manager Wilshire Associates, institutional investors face the same challenges in creating incentives for their private equity managers as they do for their public equity managers - namely, getting them to invest for long-term profits. "You don't want to create perverse incentives, where a manager is going to go select funds that deploy capital as fast as possible."
Investment committees, which oversee private equity portfolio managers, but may not entirely understand what they do, have an incentive in not only calling for the creation of private equity benchmarks, but doing it themselves. According to Venture Economics' Reyes, private equity portfolio managers exert an unusually large degree of influence in crafting benchmarks. While the creation of any benchmark at all is a step in the right direction for investing institutions, human nature dictates that, if given the opportunity, portfolio managers will select the one that is easiest to beat.