602 Benchmarks for Private Equity. Committee on Investments / Investment Advisory Committee May 16, 2005

Transcription

1 602 Benchmarks for Private Equity Committee on Investments / Investment Advisory Committee

2 SUMMARY Valid and useful benchmarks for Private Equity are not available This fact results from the absence of a market: a recognized and agreed upon universe of investment opportunities for PE fund managers Performance can only be evaluated at the end of a fund s life The use of IRRs which cannot be compared to a market index is mandated by the CFA Institute, as well as industry standard However, performance evaluation the main purpose of a benchmark can be accomplished using other metrics and processes Page 1

3 PURPOSE OF BENCHMARKS In investment management, evaluation, and oversight, a benchmark serves as a standard of measurement An appropriate benchmark will help the investor and manager determine if the management process has created value, after adjusting for risk The use of a benchmark assumes that there is an investable alternative to the active fund A valid benchmark helps the investor make investment decisions Page 2

4 PROPERTIES OF A BENCHMARK Unambiguous names and weights of securities comprising the benchmark are clearly delineated Investable option to forego active management and simply replicate the benchmark Measurable possible to readily calculate the benchmark s return on a reasonably frequent basis Appropriate benchmark is consistent with The Committee s investment preferences or biases Specified in Advance benchmark is constructed prior to the start of an evaluation period Reflecting Current Investment Opinion investment professionals in the asset class should have views on the assets in the benchmark and incorporate those views in their portfolio construction Source: Richards and Tierney; adopted by CFA Institute Incorporated in UCRP/GEP Investment Policy (IPS, Appendix 1) Page 3

5 TRADITIONAL BENCHMARKS Traditional marketable asset manager (equity and bonds) is expected to: Select securities from a recognized market (opportunity set) Take active risks relative to the market Maintain portfolio total risk similar to the market Be evaluated relative to performance of that market Provide returns in excess of passive alternatives Typical benchmark for marketable asset manager is broad or specialized capitalization weighted market index, e.g., Russell 3000 (broad) Russell 1000 Value (specialized) Meets all criteria above (page 3) Page 4

6 PERFORMANCE MEASUREMENT Time weighted vs. Dollar weighted returns Time Weighted (TWR): measures growth of a dollar, with the impact of cash contributions and withdrawals neutralized Dollar Weighted (a.k.a. IRR): measures the compound growth rate in the value of all invested assets over the period, and responds to the size and timing of external cash flows Criteria for using TWR Investments are liquid enough so that performance is unaffected by cash flows Manager controls inflows and outflows Market based pricing for valuation exists Marketable securities meet these criteria, so use of TWR is the industry standard Private Equity does not meet these criteria, hence IRRs are mandated by the CFA Institute Global Investment Performance Standards Page 5

7 PERFORMANCE MEASUREMENT FOR P.E. Measuring the performance of private equity is not straightforward (see Appendix): depends on timing and amount of cash flows, which are determined by the manager, not investor depends on interim valuations of unrealized business opportunities, which are necessarily subjective not really known until the fund is terminated; interim performance results may be meaningless No industry consistency on methods of valuation; most investments held at cost until a valuation event occurs Opportunities vary across time, so funds from different vintage years are not directly comparable Page 6

8 Benchmarks for Private Equity? There are no benchmarks - in the sense of the criteria on page 4 - that are appropriate for Private Equity Market movements only weakly impact PE valuations Especially over short periods (see next slide) TWR (market index) cannot be compared with Private Equity IRRs (vintage years) BUT, Performance evaluation for PE - the real purpose of benchmarks - can be based on two approaches: Use of other metrics (see slide 12) Comparison of long term (5-10 year) aggregate Private Equity TWR to suitable market index proxies, properly adjusted for risk (see slide 15-16) Page 7

9 SHORT TERM COMPARISONS (20) (40) Quarterly Returns of S&P 500 [X axis] vs. Venture Cap Peer Group TWR [Y axis] lagged 3 quarters (30) (20) (10) CA VC All R-Squared measures <.08 No relationship, even of lagged returns VE VC (5) (10) (15) (20) (25) Quarterly Returns of S&P 500 [X axis] vs. Buyout Peer Group TWR [Y axis] lagged 2 quarters (30) (20) (10) CA PE VE Buyout/ Mezz. Page 8

10 PROPERTIES OF A BENCHMARK Private Equity benchmarks do not exist because there is no recognized market that is, a defined aggregate of the opportunities (companies or ideas) that could potentially be chosen by Venture or Buyout fund managers: Not Unambiguous The universe cannot be defined, that is, opportunities comprising the market are subjective Which companies or ideas are worthy of investment How much capital they might need and when to invest Not Investable Not able to invest in the market; only individual funds No access to individual funds for many investors Not Measurable Not measurable because market is subjective Not Specified in Advance Not specified in advance because market is constantly changing Page 9

11 PEER GROUP BENCHMARKS? Peer group percentiles (median, top quartile) of groups of managers are not valid benchmarks Not investable, not specified in advance Suffer from survivor and selection biases Peer groups of Private Equity managers are even less valid than equity/bond peer groups Peer groups developed by only two firms, Cambridge Associates and Venture Economics They only include data from investors in their client base Not a representation of the market Clients and underlying funds move in and out of the index Historical results, even for 15 years ago, change frequently Peer group indexes are not investable, even more so as UC and many other investors are excluded from participation in many individual funds Page 10

12 P.E. BENCHMARKS - SUMMARY Peer group indexes may be useful in giving a general indication of what might be happening in the industry Academics and professionals have used long-term market data to aid the investor in the asset allocation decision (whether to invest in Private Equity as an alternative to other asset classes) But historical PE data cannot be properly compared to public market data, especially with regard to risk estimates However, the use of market or peer group data as a performance benchmark to aid in current investment evaluation and decision making has not yet been fruitful Page 11

13 PERFORMANCE EVALUATION Absence of appropriate benchmarks does not eliminate need for performance evaluation or fiduciary oversight Treasurer includes a variety of market indexes and peer group results in quarterly report for long-term comparison (slide 14) This provides an indication of value added over the long term for the entire PE program, not individual funds Evaluation uses many metrics, including Internal Rates of Return (IRR s) Cash Flow Multiples Oversight consists of Continual review of partnership investments and partnership business processes Participation on advisory boards of individual partnerships Page 12

14 UCRP/GEP INVESTMENT POLICY The Committee on Investments adopted the following Policy for the UCRP and GEP for Private Equity (Nov 2004 and Feb. 2005) Private Equity (PE) asset class: eliminate former benchmark (R3000+3%, lagged one quarter) Continue to use fund IRR s for long term performance evaluation Calculation of Total UCRP/GEP Policy Benchmark: the benchmark return for PE is identical to the actual PE portfolio return Has the effect of neutralizing the PE return, that is, the Total Fund active return excludes the impact of PE Page 13

15 UCRP/GEP INVESTMENT POLICY 2 Rationale for this benchmark change Eliminate short term PE Benchmark: There is no relevant benchmark meeting the criteria listed Former PE benchmark is not investable Does not match the risk of PE investments Does not contribute insight to either short or long term performance evaluation (which is the primary purpose of a benchmark) Remove PE component of total fund benchmark for purpose of short term performance evaluation Follows from the previous recommendation to eliminate the former asset class benchmark for PE due to the lack of an appropriate market target Page 14

16 This report is included in the Quarterly Investment Performance Summary for the Investment Advisory Committee / Committee on Investments. It shows the time weighted returns of the aggregate Private Equity Investments, and the sub categories of Venture Capital, Buyouts, and International, over multiple time periods. Various market indexes and peer group returns (Cambridge Assoc. and Venture Economics) are shown for comparison, but these may not be investable. Page 15

17 LONG TERM COMPARISONS Rolling 5 Year Compound Returns of Venture Capital vs. S&P 500 lagged 3 quarters Venture Cap 80% 70% 60% 50% 40% 30% 20% 10% 0% 40% 35% 30% 25% 20% 15% 10% 5% 0% S&P 500 Venture Cap Peer Group Indexes look like levered equity -10% -5% -20% -10% Jun-91 Jun-92 Jun-93 Jun-94 Jun-95 Jun-96 Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 CA VC VE VC S& P 500 Jun-03 Jun-04 35% Rolling 5 Year Compound Returns of Private Equity / Buyout vs. S&P 500 lagged 2 quarters 30% 25% 20% 15% 10% 5% 0% -5% -10% Jun-91 Jun-92 Jun-93 Jun-94 Jun-95 Jun-96 Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 CA PE VE Buyout/ Mezz. S& P 500 Page 16

18 Appendix Committee on Investments / Investment Advisory Committee

19 PERFORMANCE MEASUREMENT Marketable Securities Return [t] = ( P [t] P [t-1] + D [t] ) / P [t] P[t] = Price at time t, D[t] = Dividend at time t Private Equity (VC / BO) Return is the number R which satisfies: 0 = Sum [t=1 N] (CF [t] /(1+R) t ) + TV/(1+R) N Sum is over the last N periods CF[t] = Cash flow at time t (inflow or outflow) TV = Estimated Terminal Value today TV = Sum [t=1 M] (Estimated CF [t] /(1+H) t ) H = Fund Manager s hurdle rate of return Sum is over the future M periods Page 18

20 OTHER ALTERNATIVE INVESTMENTS Benchmark for Real Estate Public RE: Dow Jones-Wilshire REIT Index Portfolios consist of publicly traded securities (REITS) which are marked to market daily Similar to specialized equity index Private: NCREIF Property Index (NPI) Investments are Limited Partnerships, either closed or open-ended funds NPI returns are based on a large pool of institutional real estate in core strategies (excludes value added or opportunistic strategies) Benchmark for Absolute Return Strategies Cash (30 Day T Bills) + 4.5% per annum This fails the test of a valid benchmark on page 2, but Has become a standard for institutions in evaluating success of an AR program Represents a hurdle or expected return over cash Page 19