Becnhmarks as elusive as ever
Private equity is attracting institutions as they head off the beaten track in search of higher returns. But how can they measure the returns that venture capital generates? The asset class can prove slippery for those trying to report and compare its performance.
Chris Davison, head of research at private equity research firm Alt Assets, says proper benchmarks for private equity don’t really exist. The problem for would-be index providers in the investment sector is the lack of information available. “None of the funds are required to publish any information to anyone other than their investors, so no one can really get hold of the information on a very reliable basis,” he says.
And even where the information is available, there are other problems in collating and analysing it. Funds put their valuations together often on very different bases. There are some standard approaches for venture capital funds, but often, individual funds use their own particular method.
US investment consultant Cambridge Associates has put together a type of benchmark for the sector. It aggregates performance data from all of its clients, which means its catches sight of a lot of funds. This information is then used to create quarterly performance data. The index – the Cambridge Associates LLC US Venture Capital Index – is based on returns data from funds which represent over 80% of the total dollars raised by US venture capital managers from 1981 onwards.
Davison says the result is a rather a broad index, encompassing as it does both buyout and venture, and investment horizons of a year, three years, five years and ten years.
Cambridge Economics says it does compile data on European venture capital investment as well as US. But, though it makes this information available to clients, it doesn’t reveal it publicly.
Venture Economics, which is a part of the Thomson group, also produces data which is sourced from investors. It aggregates the information and is able to show clients how well their investment has performed in comparison with others.
The BVCA (British Venture Capital Association) produces performance data too. Its performance measurement survey gives all sorts of comparisons of private equity and venture capital returns by sector, stage, vintage year etc. It also gives comparisons with other market measures such as the FTSE return and the pension fund universe return. The EVCA – its European equivalent – now uses Venture Economics European data. In the US, the NBCA produces performance data too.
But Davison is doubtful how useful the figures are that the associations come up with. The figures that result are quite easy to manipulate, he says. “You can’t do a lot with them.” And there are concerns about the quality of the data, being as it is from fund managers themselves. The problem, he says, with getting the information from investors is that a lot depends on cash flow, when the funds were drawn down, for example. The precise timing of this can have an impact on the figures.
“There are a lot of difficulties, technically, when
trying to put together a benchmark,” he says. “That means that quite often people come up with their own benchmark. They may measure it against the FTSE All-Share or the MSCI 500 – a broad basket of public equities – and then put a notional premium on that, say plus or minus five basis points.”
There is quite a lot of pressure building within the investment industry for greater transparency of fund performance. This has been most noticeable in the US, where last year university pension schemes were required to publish information about their private equity investments.
The fund managers argued against it, saying figures in the early years can be misleading, showing a negative return which could give the impression they were losing money, though sophisticated investors would know that this is the nature of the investment class.
There is also the argument used in the industry that greater transparency might compromise the ability to generate good returns. More transparency might mean greater liquidity and therefore bargains would be harder to find.
Davison says that in the US at least, the issue of transparency within the private equity sector seems to have hit a wall for now. Private Equity Intelligence in the US used the freedom of information act to force funds to disclose, but the investment community remains split on the issue. On the one hand, if parties join forces then they can pool resources, but on the other, investors may feel that there is a premium on the information they have – and they don’t see why they should share it.
In Europe there seems to be less chance of getting reliable data, since there is not freedom of information act over here. “The situation will resolve itself at some point,” says Davison. “When the asset class has been institutionalised, there will inevitably be a private equity benchmark. But it’s going to be a while.”
Thomas Meyer, head of risk management and his colleague Pierre-Yves Mathonet at the European Investment Fund in Luxembourg are in the process of writing a book on how manage the risks of venture capital fund-of-funds investment programmes. Meyer says the European Investment Fund has its own risk model that also takes available external benchmarks data into consideration, including those offered by Cambridge Associates and Venture Economics.
He says such private equity benchmarks are useful, he says, but you need to be aware of their
shortcomings. Interim asset valuation conducted by the general partners is the most problematic aspect. However, these benchmarks give the investors at least some indication on how a private equity fund performs relative to that of its peer group and thus form a basis for managing a portfolio of private equity funds.
John Hastings, partner in the investment practice of Hymans Robertson, agrees there are difficulties in this area. One of these is the way that investors put their money into venture capital – they do this very differently from other investment types. Although they begin by committing a certain sum to a venture capital fund, this is just a commitment and doesn’t mean an actual disbursement. Money is given as and when required, and often returned well before the stipulated time scale.
From the point of view of gathering returns data, it would be hard to judge the timescale, and the amount invested.
When investors measure the performance of their own private equity investments, they do this in a very different way from measuring quoted equity, says Hastings. They calculated the internal rate of return by vintage years. If, for example, the investment was launched in 1988, each year since would be calculated.
“But it’s a very backward-looking exercise, because it’s only when all the money is returned to investors that the calculation is possible,” he says.
Valuing businesses in venture capital funds is also notoriously difficult. Sometimes turnover is used, and the company may be compared against another business in the same industry. Or in other cases, a business has managed to get 10% of its share capital quoted – but here, too, it may be misleading to assume that the rest of its share capital would have a similar per-share value.
Businesses within the private equity sector are very different from each other too, says Hastings. “Comparing one portfolio with another – it’s very much an apples and pears comparison.”
And not just the businesses within them, but all venture capital companies are different. Some are buyout only and some specialise in information technology – to name but too types.
“I don’t think there’s any way it can be sensibly benchmarked,”
he says. For investors, succeeding in the private equity sphere is a matter of choosing a manager with a good reputation and strong