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The challenge of performance assessment

Despite advances during the past decades in the pricing and risk adjustment of return in public markets, the measurement of risk and return in private equity has advanced relatively little. This is surprising, given the importance of return measurements for both fund managers and private equity investors. Paul Gompers and Josh Lerner, both fellows at the National Bureau for Economic Research discuss. (Extract)

This article is extracted from Private Equity and Venture Capital with the kind permission of Euromoney Books (a division of Euromoney) Email books@euromoneyplc.com for further information about this title.

The benchmark chosen to measure performance is critical in determining an institutional investor's decision to allocate funds across various asset classes, as well as the choice of individual managers within an asset class. Universities and foundations that spend a certain percentage of their endowments must be able to calculate the change in valuation of their private equity portfolios from year to year. Investment officers at pension funds whose bonuses are tied to the performance of their portfolios must similarly be able to measure accurately how well these funds are performing on a risk-adjusted basis in a timely manner.

At the same time, the relatively slow pace of innovation in assessing riskiness and returns for private equity investments is understandable. Firms receiving capital from private equity funds very often remain privately held for a number of years after the initial investment. These firms have no observable market price. In order to present a conservative assessment of the portfolio valuation, private equity managers often refrain from marking to market portfolio firm values, preferring to maintain the investments at book value. Thus, the stated returns of private equity funds may not accurately reflect the true evolution of value.
    
The problem is severe for both venture capital and buyout investments. In fact, current practices may substantially understate the true volatility of buyouts because they rarely have follow-on investments when the firm can be revalued.
    
The problem

Two primary approaches have been taken in earlier efforts to assess the returns of private equity investment. The first has been to examine the change in the prices of firms backed by private equity investors that have recently gone public. A long-standing example of such an index is the Venture Capital 100 reported each month in Venture Economies' Venture Capital Journal. Merrill Lynch has taken a similar approach in the construction of its private equity index: It uses the prices of the least liquid listed public firms with the smallest market capitalisation.'
    
While such an index is relatively easy to construct in a timely manner (the prices of publicly traded firms can be obtained at the end of each trading day), it has several limitations.
    
First, the valuation of private equity investments will be affected by a variety of factors that do not affect public firms. For instance, a considerable inflow of funds into venture funds may create an environment where 'too many funds are chasing too few deals'. It seems unlikely that such a problem will affect the pricing of public firms, as public investors can readily move their capital across industries and securities.
    
Second, the market for recently public firms has certain institutional features that affect the pricing of firms. For instance, smaller firms that go public frequently drop in value in their first few years, which may reflect over-optimism, at least by some subset of investors. These institutional changes once again reduce the value of public firms as indicators of private valuations. Finally, the public firms that make up the indexes may not be good proxies for the current mix of private equity-backed firms. Many of the new private firms may have no public comparables.

The second approach has been to calculate the internal rates of return (IRR) of private equity funds. Among others. Venture Economics and Cambridge Associates collect data from institutional investors on the flow of capital into and out of private equity funds. These data are used to calculate annual and quarterly return series for private equity funds as a whole. These calculated returns are then used to compare the returns of private equity with small capitalisation stocks and other securities, as well as to determine the relative performance of particular private equity organisations.
     
Unfortunately, this methodology also has two major problems, which limit its usefulness. The first is the inconsistency in how private equity groups value their investments. Established private equity organisations are usually conservative in their approach to valuing their investments, often holding investments at cost until they are taken public. Less established private equity organisations are often not as conservative in their valuation practices. Inexperienced private equity groups are often under tremendous pressure to raise follow-on funds.
      
Raising an initial private equity fund is frequently very difficult. Many institutional investors and investment advisers refuse, as a matter of principle, to invest in first-time funds, often on the grounds that they believe these funds have lower returns than other partnerships. As a result, many first-time funds are so small that the management fees generated cannot cover the travel, office and salary expenses that the partnerships incur.
      
Alternatively, the lead investor in the fund (and perhaps even the placement agent who helped in the fund-raising) may be given a substantial share of the management fees and carried interest. The general partners of the private equity fund are nonetheless willing to accept these terms, because they expect that subsequent funds will be raised on more attractive terms. A major focus of these organisations is consequently on raising such a follow on fund.
     
It is not surprising, then, that these private equity organisations are very aggressive in presenting their investment results during fund-raising. Among the behaviours encountered are:
 •  aggressively valuing still-private firms in their portfolios above cost;
 •  neglecting to discount firms in the portfolio that have encountered difficulties; and
 •  failing to discount for the illiquidity of the shares of publicly traded firms still held in the private equity group's portfolio.
     
These problems may not always be identified by institutional investors, who often are surprisingly willing to accept such claims at face value. Because a much larger fraction of established private equity organisation investments are likely to have been liquidated, these problems are much less likely to have a material impact on their results. Differences in valuation methodology can give the appearance that certain groups have superior performance when interim returns are compared, while in actuality their long-term performance is no different (or even lower) than that of other organisations.
    
The inconsistency has been the subject of attention by institutional investors in the United States and elsewhere. Efforts in the United States, such as the initiative launched in 1989 by the Institutional Limited Partners Association (ILPA), have made only modest progress. In the United Kingdom, however, the British Venture Capital Association (BVCA), in conjunction with a group of major limited partners, has taken an aggressive approach in addressing this problem. In 1991, it introduced a consistent set of valuation standards that its members must follow.The aim is to standardise the valuation of privately held firms in the private equity organisation portfolios. In particular, it seeks to prevent incidents where private equity investors raise follow-on funds (often from retail investors) based on inflated valuations of still private firms.
    
These standards were made more specific in 1993 in response to claims that private equity organisations were exploiting 'loopholes' in the standards. Many observers have criticised the revised standards as well, arguing that they still allow too much room for manoeuvre. For example, the distinction between early- and late-stage firms is not precisely defined. Thus, despite the much greater progress made in the United Kingdom than in the United States or elsewhere, it is unclear whether or not the BVCA's efforts have succeeded in curbing many problematic instances of aggressive valuations by less-established private equity organisations.
    
Even is this problem can be addressed, however, there is a second issue. The practices of the established venture groups, as well as the reform efforts, such as the BVCA initiative,emphasise the computation of returns using conservative assumptions. While these procedures allow investors to compare the performance of different private equity funds and to avoid being misled by overly aggressive organisations, they make it difficult to compare private equity returns to those in other asset classes. Thus, while it may be possible for private equity organisations to demonstrate that their funds have outperformed other partnerships formed around the same time, it is very difficult for them to show that they have produced positive risk-adjusted returns for their investors relative to the equity market as a whole.
   
A key obstacle to such comparisons is what can be termed the 'stale price' problem.While the movements of public market indices can be observed on a daily basis, increases in the value of private firms can only be observed by outsiders after a great deal of delay. Typically, there is a sudden jump in the valuation of a firm reported by a private equity group associated with its initial public offering or a third-party follow-on investment, rather than a gradual increase in value as the company builds up its sales and profitability.
    
As a result of this problem it is very difficult to compare public and private equity prices.An illustration of this difficulty is to think about a hypothetical setting where:
•  the valuation of private equity portfolios exactly mirrors the movements of the Standard& Poor's 500 (S&P 500); but
•  returns from private equity funds are observed with a one-day delay.

If we try to relate the observed daily private and public equity returns, we would find virtually no correlation. (The S&P 500's movements on a given day have little predictive power for its movement on the following day.) This might lead us to conclude falsely that there is no relationship between these two asset classes.
    
This problem has been acknowledged by experienced observers of the private equity industry. To cite one discussion from the Venture Capital Journal:
         
'Venture Economics has often been asked in the past to comment on the performance of venture capital relative to other asset classes. It is imperative that any asset classes being compared be measured on the same basis [but] market prices for private venture capital partnerships don't exist... Therefore, objective comparisons of risk and reward relative to other public markets are difficult to justify.'
    
Despite the widespread acknowledgement of this problem, few efforts have been made
to date to address this concern.

Paul A. Gompers
Associate professor at the Harvard Business School and faculty research fellow of the
National Bureau of Economic Research

Josh Lemer
Professor of Business Administration at the Harvard Business School and research associate of the National Bureau of Economic Research

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