What’s wrong?

The absence of credible, complete, and standardized information has been a persistent issue hampering the growth of private markets. Private market funds are not required to disclose performance information publically; the current practice is for individual funds to self-report their performance to their investors only.

Financial Regulators do not regulate the current benchmarks for private markets (as it is done for Credit ratings), nor are these benchmarks published in compliance with IOSCO’s Principles for financial benchmarks framework – a global standard that promotes transparency and avoids conflict of interest. Even more worrisome is the fact that incentives for the benchmarking agencies are not aligned with the long-term goals of Limited Partners, as these agencies act as data providers or consultants to General Partners (an incentive structure followed by Credit rating agencies that caused the 2008 crisis).

The absence of a framework for performance reporting augmented by a lack of governance framework for benchmarking agencies makes the current performance benchmarks more susceptible to manipulation – a study published using three popular data sources found that even modest variation in methodology can result in half of all the funds being able to claim top quartile results(1). Evidence also points toward an upward bias in the current benchmarks(2).

The ‘Two and Twenty is a standard fee structure for intermediaries in the private markets where they charge investors an annual management fee of 2% of the assets plus an incentive fee of 20% of funds gains. Over the last few decades, private markets have grown manifold, witnessing an influx of capital. This has skewed the incentive structure for intermediaries, and a significant portion of the incentives is being driven by the annual management fee(3), making fund managers prosper if their assets under management grew very large, not necessarily if they just performed well for their clients.

This drift in incentives is further skewed by the industry’s reliance on IRR as a performance measure, which is more sensitive to early returns and disincentivizes long-term investing.

“David Swensen and others worried that unless the investors were forced to rely on performance-based compensation for the bulk of their compensation, their incentives could erode. Also, they worried that there could be real pressures to invest, perhaps tempting a firm to reach for deals or to extend beyond their real areas of expertise.
-Yale Investments Office Case study, Harvard Business School

The apprehension shared by David Swensen and others was reiterated by a study conducted to understand the effect of complexity on portfolio performance. The study concluded that groups that experienced increased portfolio complexity, frequently associated with growth, suffered poorer returns(4).

The idiosyncratic approaches to computing performance and risk indicators using dissimilar datasets also pose a question on the reliability of the publications.

“With the data that I have gathered over 15 years, from different limited partners; If I try to publish using the data, a standard response you get from academic journals is ‘How representative is your sample?’

-Prof. Oliver Gottschalg, Private Equity Observatory – Buyout Center.

Available data sets also have different biases inscribed; Studies conducted to evaluate the persistence of performance in the private markets using these dissimilar datasets have resulted in contradicting conclusions and deepened the puzzle of the stickiness of performance in the industry.

The regulator’s response lacks teeth to resolve the industry’s two-fold problem, i.e., the lack of information on a matrix of asset performance and the lack of credible sources for such information.

India: Securities Exchange Board of India (SEBI), the Indian financial markets regulator, issued a circular in February 2020 mandating all Alternative Investment Funds to pool performance data and publish a benchmark. The SEBI notification requesting self-regulation by the AIFs was seen as a great opportunity for the asset class to leap forward toward transparency and boost investor confidence. However, the framed regulation lacked teeth(5) and concluded by publishing pooled cash flow benchmarks – ignoring the common mistake of aggregation of IRR.

United States: SEC has proposed new rules to enhance the regulation of private fund advisers and to protect private fund investors by increasing transparency, competition, and efficiency in the $18-trillion marketplace(6). The proposed rules would increase transparency by requiring registered private fund advisers to provide investors with quarterly statements detailing certain information regarding leverage, fund fees, expenses, and performance. Previously, SEC had also established a sub-committee to assess retail investor access to private markets(7). Reiterating the learnings highlighted by Jonathan Berk’s article published in the aftermath of the 2008 financial crisis – the regulatory response would be insufficient to solve the problems in the absence of measurement and reporting standards that re-align the incentives:

“It is naive to believe that it is possible to control these incentives by passing tough new laws regulating specific activity such as the amount of leverage. Such regulation would soon become archaic as investment bankers invent new financial products that could achieve the same results without running afoul of the regulations. Instead, legislators should consider reorganizing the industry to better align its incentives with the public interest.

– Jonathan Berk, ‘Vantage Point: Incentives and the financial crisis’

Why now?

The need to advance the study of private markets is catalyzed by the emergence of new segments such as private debt, new financial developments such as the use of subscription lines of credit, and in light of recent co-investing and direct investing efforts.

New segments: Publishing relevant & transparent performance benchmarks is paramount for sustaining dynamism in the industry. Transparent benchmarks allow the investment teams to assess how investment decisions have performed in terms of relative risk & reward and define strategic asset allocation decisions by weighing the opportunity costs of investing in other models of private equity such as search funds or private debt.

New Financial developments: The agile financial industry has developed financial products to streamline the investment process. One such recent development is the use of Subscription Lines of Credit – a bridging facility offered by banks to fund managers (general partners) that enables the funds to make early investments or pay fees and expenses without the need for irregular capital calls from the fund’s investors (Limited Partners). These facilities are secured against the capital committed by a limited partner. The Subscription Line of Credit is a win-win for both parties as it allows fund managers to make investments quickly while smoothing cash flow operations for investors.

However, one of the consequential effects of using bridging facilities is that it creates an upward bias in the Internal Rate of Return, a widely used performance indicator. The current performance reporting does not factor in the distortion caused by such bridging facilities.(8)

Co-investing and Direct investing efforts: Compensation paid to fund managers has been a spirited point of debate in private markets. In an effort to cut down on the compensation paid to fund managers, investors have tried to disintermediate the financial industry, either by investing directly (direct investing) or jointly with other professional investors and fund managers (co-investing). Conventional wisdom would dictate that co-investing yields higher returns via shared transaction costs. However, the results are quite to the contrary, as Co-investments tend to underperform the investments of the corresponding funds with which they co-invest. This underperformance appears to be driven by selection (a “lemons problem”): institutional investors can only co-invest in deals that are available to them. This suggests that fund managers offer them investments in below-average quality deals, which results in adverse selection, translating into lower gross returns that may not be offset by reduced fees and carry(9).

The ‘Lemons Problem’ was explained by George Akerlof, Michael Spence, and Joseph Stiglitz in their Nobel prize-winning paper ‘The Market for Lemons: Quality Uncertainty and the Market Mechanism.’ The paper examines how the quality of goods traded in a market can degrade in the presence of information asymmetry between buyers and sellers, leaving only “lemons” behind. Co-investments are indeed transactions with big information problems. While private capital groups have been working on the transactions for months or even years, co-investors frequently have to plow through a massive amount of information in a data room and decide within two weeks whether they want to invest.

Rethinking measurement and instilling a better way of storytelling

Public and private markets are exiting from a world of massive and predictable control liquidity injections that over-facilitated a seemingly endless flow of money into a smaller set of investment opportunities. Over the next year, private markets are likely to experience a paradigm shift – from the seller to buyer’s markets(10). This highlights the collaborative role played by industry bodies such as ILPA, regulators, and information agencies (credit rating agencies, benchmarking agencies, and data providers) as financial flows get more selective. Keeping in mind their long-term commitment to society, private markets need to reconsider measurement and instill a better way of storytelling.

Inappropriate or misunderstood measurement schemes can actually be counterproductive and sway institutions towards a short-term investment orientation(11). Analyzing the performance reporting and policy benchmarking of the university endowments, which as a pool of capital are subject to less public scrutiny and fewer constraints on investment thereby enjoying more flexibility than other pools such as Pension Funds. Using a linear axis with no benchmarks to the most detailed reporting in the industry i.e the Yale endowment standard, other endowments in the midst claim to be winning the top quartile result; one of the endowments uses two benchmarks to claim top quartile result using a broader population benchmark alongside the commonly used benchmark such that the 50 percentile of the commonly used benchmark approximates the 25 percentile of the benchmark with the broader population.

The use of Benchmarks for the public market is also ambiguous, signaling a phenomenon known as shopping for benchmarks. The benchmarks used by the university endowments have 10-year annualized returns that span from 13.8% (S&P500 Total return index) to 7% (MSCI All country world Index). Another cautious practice is of adding premiums to the benchmarks, commonly witnessed in pension funds. The premium introduces a non-market force, which is always positive and is not volatile which distorts comparison.

Limited partners should move towards stakeholder-centric performance reporting explaining whether the economic rent charged by external managers and internal managers (by co-investing & direct investing) is offset by the value generated, even if it involves simpler and more understandable measures of risk & return. By instilling a better way of storytelling and factoring risk in performance measurement the LPs should be able to justify that financial intermediaries are rewarded for risk-taking. Being consistent and transparent about an approximate value for risk is preferable to either ignoring it or spending excessive energy on precise but short-lived quantifications(12).

Notes:

1. Are too many private equity funds top quartile Robert S. Harris and Rudiger Stucke
2. The performance of private equity funds as reported by industry associations and previous research is overstated. Ludovic Phalippou and Oliver Gottschalg, “The Performance of Private Equity Funds”
3. We observe that two-thirds of the fee bill come from management fees and only a third comes from incentive fees Ludovic Phalippou and Oliver Gottschalg, “The Performance of Private Equity Funds”
4. Giants at the Gate: Investment Returns and Diseconomies of Scale in Private Equity. Florencio Lopez-de-Silanes, Ludovic Phalippou, and Oliver Gottschalk
5. The SEBI regulation was issued on the recommendation of the Alternative Investment Policy Advisory Committee (AIPAC) committee, which also recommended publishing performance benchmarks, distribution of performance metrics, and relevant PME benchmarks. However, the SEBI regulation – through the first of a kind in the world, had an agency problem whereby the association of the General partners negotiated the terms of the benchmarking specifically negotiating not publishing distribution of performance metrics – which is essentially important considering the high dispersion of return in private markets. In the end, only pooled cash flow benchmarks were published, committing the common error of aggregating IRR.
6. SEC Proposes to Enhance Private Fund Investor Protection https://www.sec.gov/news/press-release/2022-19
7. The Asset Management Advisory Committee (“AMAC”) established a subcommittee to review retail investors access to private investments (the “PI Subcommittee”)https://www.sec.gov/files/final-recommendations-and-report-private-investments-subcommittee-092721.pdf
8. Howard Marks highlights other risks associated with the use of bridging facilities in his memo Lines in sand https://www.oaktreecapital.com/docs/default-source/memos/lines-in-the-sand.pdf
9. The Disintermediation of Financial Markets Lily Fang, Victoria Ivashina & Josh Lerner
10. Private equity cannot avoid reckoning in markets, Mohamed El-Erian
11. Measurement Governance & Long-term investing, World economic forum
12. Measurement Governance & Long-term investing, World economic forum