Benchmarking in the Private Markets: The Four Minute Mile

February 18, 2022
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All of these things are benchmarks: a measuring stick we use to assess the relative success or failure of a venture. Some benchmarks are better and more objective than others. It’s easy to get two Philadelphians to agree that running a mile in four minutes is fast, but good luck getting them to agree on the best spot to order a cheesesteak (though most would agree that the roast pork sandwich, not the cheesesteak, is the true king of Philadelphia sandwiches). 

In investment management, benchmarking is a critical part of assessing an investment portfolio. How else would you know whether the 10% return your public equity portfolio generated last year is cause for celebration or cause for reevaluating how your portfolio is managed? In a vacuum, that 10% return may sound attractive. But, if a global listed equity benchmark (the MSCI ACWI in this case) returned 33% in the year leading up to July 30, 2021, that 10% return may not sound so good.

Anyone doing research on investment management benchmarks has likely stumbled across the CFA Institute’s criteria for an ideal benchmark. We’re not the first group to show these criteria (and we won’t be the last) but we’ll repeat them here since they’re important:

Property 

Description 

UnambiguousNames and weights of all portfolio securities in the benchmark should be clearly delineated
MeasurableThe investor should be able to calculate returns to the benchmark reasonably frequently
InvestableThe investor should have the option of adopting a totally passive approach by investing in the benchmark itself without disruption of the market
AppropriateBenchmark should be consistent with the style of the investment manager whose performance is being gauged
Specified in AdvanceBenchmark computation should be constructed prior to the start of an evaluation period
Reflective of Current Investment OpinionAll participants in the market must be able to have current knowledge of the benchmark

Source: Bailey, The Journal of Portfolio Management, Spring 1992

Commonly used benchmarks for publicly traded assets, like the S&P 500, the Russell 3000 or the Barclays Aggregate Bond Index, meet the criteria above. There is a menu of quality benchmark options available for nearly any style (geographic specific, sector specific, etc.) of public market investment. 

But what about benchmarks in private markets? We’ve been investing in private markets at Hamilton Lane since Boyz II Men’s first platinum album was released, so surely you would assume that we have come across a private market benchmark in our 30 years of existence that checks all of the boxes above. 

We wish that were the case. Thus far, all private markets benchmarks have failed to fulfill the CFA criteria. Most private markets benchmarks are not, in practice, investable.  The composition of some private markets benchmarks is ambiguous. There is disagreement among the private markets community on what is the “best” performance or technique metric to use. What gives?

The Data Challenge

Easily the highest hurdle to creating a consensus, high quality private markets benchmark is the scarcity  of private markets fund performance data. The private markets are an asset class where detailed, high quality performance data is incredibly difficult to come by. For all of the potential benefits private markets investments may offer investors, it is the worst asset class for data and transparency. 

For this discussion, we’ll focus on the challenges associated with benchmarking private markets funds. While co-investments – direct investments in private companies made by the end investor rather than through a traditional fund manager – have gained in popularity in recent years, most investors still get the majority of their private markets exposures through private markets funds.

Most regulatory codes stipulate only spartan reporting requirements for private markets funds. More recently, many general partners (GPs) have acquiesced to investor requests to provide additional data. However, historically, GPs have been loath to report much more than the bare minimum required by law. The bare minimum typically involves issuing capital calls or distribution notices as needed, reporting  aggregate fund net asset value on a quarterly basis, and providing a list of the fund’s investments. That information is only reported to the limited partners (LPs) that are invested in the fund.

So how do data providers collect data on private markets funds if all of the crucial information is not directly reported to the general public? While the industry has made it difficult to collect data, it’s not impossible:

Methodology

Description

Pros

Cons

Regulatory FindingsFund managers must file some paperwork with regulatory bodies to register their investment vehicles
  • Standardized information
  •  Easy to collect
  • Generally limited to fundraising information, firm news 
  • Little performance information available
Public RecordsTransparency laws compel public pension plans to release information regarding their investment activities
  • Public pensions are some of the largest, longstanding private market investors- large trove of data
  • Performance information available
  • May lack cash flow, interim valuation data
  • Inability to verify/standardize reported figures 
  • Does not compel corporate pensions, SWFs endowments or other private investors to release data publicly
FOIA (Freedom of Information Act)Citizens may request for additional data from government entities that may not have been otherwise released publicly
  • Allows for collection of additional/more detailed information from public pension plans 
  •  Most developed countries have public record request laws in place
  • Request may be rejected or take significant time to be fulfilled. Data may be stale by the time it is obtained 
  •  Some desirable data still protected by confidentiality laws
GP Voluntary ContributionsFund managers voluntarily submit performance information to data providers
  •  GPs may provide more detailed information than what is available via public records or filings 
  •  Backfill missing funds from a GP’s track record 
  •  Capture funds that lack a public pension investor base
  •  Inability to verify/standardize reported figures
  •  Potential to introduce survivorship bias 
  •  Data providers may create incentives for GPs to contribute (or not contribute) based on how the data will be displayed
LP Voluntary ContributionsFund investors voluntarily submit performance information to data providers
  • High quality, detailed data - backed by financial statements received by LPs
  •  Representative of the actual LP experience  
  • Ability to verify/standardize performance figures
  • Difficult to convince critical mass of LPs to submit data - too few LPs can bias dataset
  •  Data must be shown aggregated and anonymized

None of these methodologies are perfect. Some limit the level of detail that can be collected. Others are difficult to execute or audit. No data provider has yet been able to capture data on 100% of the market. Private markets benchmarks are the Rocky V of benchmarks.



Approaches

The relative dearth of private markets data does not mean that benchmarking exercises for private markets portfolios should be ignored. On the contrary, it makes developing a benchmarking plan even more important. 

Hamilton Lane’s benchmarking philosophy is that the benchmark that you select for your private market portfolio should reflect the goals, needs, and constraints of that same portfolio. There are two pieces to executing that benchmarking philosophy: public market comparisons and private markets comparisons. We recommend using both techniques to assess different aspects of the portfolio.

Public Market Comparisons

Public market comparisons help investors evaluate the success of their private markets portfolio relative to other asset classes. In other words, they help evaluate the opportunity cost of foregoing an investment in publicly traded instruments in order to make an investment in a private markets portfolio. Public market comparisons can also be used to evaluate whether a manager has demonstrated investment skill or whether managers are a beneficiary of rising global markets. The challenge with public market comparisons is that private market returns are usually quoted using a different metric (IRR) than public market returns (time-weighted return, or TWR). Experienced analysts are careful to avoid mismatched comparison metrics, using one of the two techniques below to put these two asset classes on an equal playing field. There are two computational techniques for evaluating private markets performance relative to public market indices. The first is by using time-weighted return. When a TWR benchmark is used, the analyst is attempting to quote private market returns in the same manner that public market returns are usually quoted. TWRs in private markets are calculated on a quarterly basis since interim valuations are reported quarterly. Those quarterly TWRs can then be compounded and annualized in order to produce an annualized TWR over the desired time horizon.

The second method, perhaps more popular with academics and practitioners, is called a public market equivalent (PME). This methodology takes the opposite approach – it tries to quote the public market returns in the same manner that private markets returns are usually quoted. The first PME methodology was developed by Austin Long and Craig Nickels and the mechanics were intuitive: any time a capital call occurs, simulate a share purchase in the desired reference index; any time a distribution occurs, simulate selling shares in the reference index. The purchases and sales will result in a share balance, the value of which is determined by the index price as of the date performance is being calculated. In mathematical shorthand, the value of the simulated share balance is:

NAV PME= Σ FV(Contributions)-Σ FV(Distributions)

The PME return is determined by calculating the IRR of the private markets portfolio cash flows plus the value of the simulated share balance.

PME tries to quote the public market returns in the same manner that private markets returns are usually quoted.


Is one of these two computational approaches superior? That depends on the situation. At Hamilton Lane, we use both TWR and PME to benchmark portfolios, though the use cases for those metrics are different. In general, TWR is appropriate for benchmarking mature portfolios with a relatively constant amount of capital at work. Many LPs also prefer TWR as a shorthand, straightforward benchmark since, given that most other assets in their portfolios are evaluated on a TWR basis, it fits within the framework used for benchmarking the rest of their portfolio. TWR does not work well for benchmarking immature portfolios or for benchmarking individual managers due to the way the annualized TWR calculation equally weights all periods – even periods where very little capital is at work. For those scenarios, a PME approach would be more appropriate. PME can also be used on more mature portfolios, and we believe is therefore often the safer approach to benchmarking.


Time-Weighted Return (TWR)

Public Market Equivalent (PME)

Advantages
  • Standard methodology for measuring returns of publicly traded assets
  • Simple to calculate
  • Investable
  • Takes into account timing & sizing of cash flows
  •  Favored by academics
Disadvantages
  • Equally weights all time periods - may overweight periods where little capital is at work
  • Many flavors of PME - which  to choose? 
  • Most methodologies are not investable
  • More difficult to calculate
PM Benchmarking Use Cases
  • Horizon benchmarks for mature portfolios with  a stable capital  base
  • Volatility/risk calculations
  • Horizon and since inception benchmarks for both mature and young portfolios 
  • Vintage year performance benchmarks
  •  Single fund/manager benchmark


Private Markets Comparisons

The second component of our benchmarking philosophy involves comparisons of a private markets portfolio to the private market industry, otherwise known as peer set benchmarking. This analysis gives the LP a view of how well its private markets portfolio is performing relative to the other choices it had within the asset class. Has the LP been a good fund picker and/or portfolio manager?

The challenge with private markets comparisons goes back to the data issue highlighted earlier. It is critical for LPs to use the highest quality, most comprehensive private markets datasets available to them. Hamilton Lane assesses data providers on a few different criteria:

Data quality: does the data provider have the ability to independently verify the figures in its dataset? Can it trace the data points back to financial statements or legal documents?

Data completeness: is the provider able to collect a full slate of data points about each fund? Is the provider able to consistently collect those data points across all the funds it tracks?

Total industry coverage: how much of the total private markets industry does the database track performance data for? Does the database have consistent coverage for different private markets strategies?

Total institutional coverage: some data providers bolster their headline fund count by tracking sub-institutional quality funds – the friends and family venture fund or the $25M buyout fund that only did a few deals. These are funds that most sophisticated LPs would not consider. Does a significant portion of the data provider’s sample consistent of sub-institutional quality funds?

Given a quality dataset, the implementation of private markets comparisons is straightforward. At the fund manager level, performance is usually sliced by the vintage year and the strategy of the fund. In some cases, it can be appropriate to develop a more targeted peer set that includes only the most comparable funds.

The most popular framework for evaluating a manager relative to its peers is to divide the universe of peers into quartiles with rankings determined by a performance metric. In most cases, the performance metric used to determine a fund’s rank is the since inception IRR, though it is also informative to evaluate a fund on TVPI and DPI. Whether a fund ranks in the top quartile (ranks among the top 25% of the peer set) is, in the eyes of many investors, a signifier of whether the fund has been successful.


Source: Cobalt LP

 

Private markets comparisons can also be used to assess the health of the total portfolio. We do not recommend comparing a private markets portfolio to a quartile ranking of funds – this would be akin to comparing a public stock portfolio to the distribution of individual stock returns. Given the wider dispersion of returns among the individual components, this is not a relevant comparison.

Instead, a more appropriate comparison would be to compare the private markets portfolio’s return to a pooled private markets industry return. This would be akin to comparing the performance of a public stock portfolio to the performance of the S&P 500. Comparisons should be run over a variety of time horizons and can be sliced or filtered by strategy and/or geography to either create an industry benchmark that mirrors the constraints of the portfolio; or evaluate the performance of sub-portfolios (i.e., the buyout portion portfolio or the emerging market portion of the portfolio).


Source: Cobalt LP

 

Other Benchmarking Approaches

Given the imperfect nature of both public market comparisons and private markets comparisons, it is unsurprising that some practitioners have proposed alternate methodologies. Unfortunately, these alternate methodologies often present more challenges than solutions.

Some LPs have considered setting an absolute return hurdle as the benchmark for their private markets portfolios. The thought is that there is some absolute long-run return the portfolio must achieve to justify the risks taken in the portfolio or to fund the liabilities of the LP. The selection of the absolute return hurdle can be arbitrary, is not reflective of the opportunity cost of other investment types, and, since an absolute return hurdle does not fluctuate, will produce large tracking errors. Private markets funds tend to be equity strategies rather than absolute return strategies.

Other LPs have asked whether the shares of publicly listed GPs should be used as a benchmark. Perhaps the share prices of these large, diversified managers can be used as a proxy for the performance of the private markets as whole. After all, if the GP’s funds perform well, it should receive more fees and carried interest, which should raise the share price.

To date, we observe little evidence of a correlation between the performance of private markets and the performance of the share price of listed GPs. The dynamics that influence the share price of listed GPs (management fee revenue, AUM growth, public perception) are independent of the dynamics that influence their underlying private markets investments. Owning a stake in a GP’s management company is ultimately a much different investment than owning a stake in one of its funds.

Conclusion: We end this discussion with a difficult truth: there is no perfect private markets benchmark. There are, however, best practices that LPs can adopt to get a more complete view of the performance of their private markets portfolio.

  • Adopt a dual-pronged approach to benchmarking: use both public market comparisons and private markets comparisons. These comparisons serve different purposes. Both are valuable. 
  • For public market comparisons, make sure the performance metric used for the public market index is comparable to the performance metric used for the private market portfolio. PME vs. IRR is generally the safest comparison. 
  • For private markets comparisons, use the highest quality data available. Quality over quantity. Ask your current data provider how it’s sourcing and verifying its data. Is it collecting the level of detail you need?

Disclosures 

This presentation has been prepared solely for informational purposes and contains confidential and proprietary information, the disclosure of which could be harmful to Hamilton Lane. Accordingly, the recipients of this presentation are requested to maintain the confidentiality of the information contained herein. This presentation may not be copied or distributed, in whole or in part, without the prior written consent of Hamilton Lane.

The information contained in this presentation may include forward-looking statements regarding returns, performance, opinions, the fund presented or its portfolio companies, or other events contained herein. Forward-looking statements include a number of risks, uncertainties and other factors beyond our control, or the control of the fund or the portfolio companies, which may result in material differences in actual results, performance or other expectations. The opinions, estimates and analyses reflect our current judgment, which may change in the future. 

All opinions, estimates and forecasts of future performance or other events contained herein are based on information available to Hamilton Lane as of the date of this presentation and are subject to change. Past performance of the investments described herein is not indicative of future results. In addition, nothing contained herein shall be deemed to be a prediction of future performance. The information included in this presentation has not been reviewed or audited by independent public accountants. Certain information included herein has been obtained from sources that Hamilton Lane believes to be reliable, but the accuracy of such information cannot be guaranteed. 

This presentation is not an offer to sell, or a solicitation of any offer to buy, any security or to enter into any agreement with Hamilton Lane or any of its affiliates. Any such offering will be made only at your request. We do not intend that any public offering will be made by us at any time with respect to any potential transaction discussed in this presentation. Any offering or potential transaction will be made pursuant to separate documentation negotiated between us, which will supersede entirely the information contained herein. Certain of the performance results included herein do not reflect the deduction of any applicable advisory or management fees, since it is not possible to allocate such fees accurately in a vintage year presentation or in a composite measured at different points in time. A client’s rate of return will be reduced by any applicable advisory or management fees, carried interest and any expenses incurred. Hamilton Lane’s fees are described in Part 2 of our Form ADV, a copy of which is available upon request.

The following hypothetical example illustrates the effect of fees on earned returns for both separate accounts and fund-of-funds investment vehicles. The example is solely for illustration purposes and is not intended as a guarantee or prediction of the actual returns that would be earned by similar investment vehicles having comparable features. The example is as follows: The hypothetical separate account or fundof- funds consisted of $100 million in commitments with a fee structure of 1.0% on committed capital during the first four years of the term of the investment and then declining by 10% per year thereafter for the 12-year life of the account. The commitments were made during the first three years in relatively equal increments and the assumption of returns was based on cash flow assumptions derived from a historical database of actual private equity cash flows. Hamilton Lane modeled the impact of fees on four different return streams over a 12- year time period. In these examples, the effect of the fees reduced returns by approximately 2%. This does not include performance fees, since the performance of the account would determine the effect such fees would have on returns. Expenses also vary based on the particular investment vehicle and, therefore, were not included in this hypothetical example. Both performance fees and expenses would further decrease the return. Hamilton Lane (UK) Limited is a wholly-owned subsidiary of Hamilton Lane Advisors, L.L.C.

Hamilton Lane (UK) Limited is authorized and regulated by the Financial Conducts Authority. In the UK this communication is directed solely at persons who would be classified as a professional client or eligible counterparty under the FCA Handbook of Rules and Guidance. Its contents are not directed at, may not be suitable for and should not be relied upon by retail clients.

Hamilton Lane (Germany) GmbH is a wholly-owned subsidiary of Hamilton Lane Advisors, L.L.C. Hamilton Lane (Germany) GmbH is authorised and regulated by the Federal Financial Supervisory Authority (BaFin). In the European Economic Area this communication is directed solely at persons who would be classified as professional investors within the meaning of Directive 2011/61/EU (AIFMD). Its contents are not directed at, may not be suitable for and should not be relied upon by retail clients.

Hamilton Lane Advisors, L.L.C. is exempt from the requirement to hold an Australian financial services license under the Corporations Act 2001 in respect of the financial services by operation of ASIC Class Order 03/1100: U.S. SEC regulated financial service providers. Hamilton Lane Advisors, L.L.C. is regulated by the SEC under U.S. laws, which differ from Australian laws.

Any tables, graphs or charts relating to past performance included in this presentation are intended only to illustrate the performance of the indices, composites, specific accounts or funds referred to for the historical periods shown. Such tables, graphs and charts are not intended to predict future performance and should not be used as the basis for an investment decision.

The information herein is not intended to provide, and should not be relied upon for, accounting, legal or tax advice, or investment recommendations. You should consult your accounting, legal, tax or other advisors about the matters discussed herein.

The calculations contained in this document are made by Hamilton Lane based on information provided by the general partner (e.g., cash flows and valuations), and have not been prepared, reviewed or approved by the general partners. As of September 17, 2021

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