Private Equity Benchmarking: Best Methods & Limitations

Private equity (PE) is one of the most rewarding asset classes for investors, but it is also one of the most difficult to evaluate due to its illiquid nature, long investment horizons, and lack of readily available public data. For this reason, benchmarking private equity investments against appropriate market indicators is essential for understanding performance, managing risk, and making informed investment decisions. However, benchmarking private equity can be complex and fraught with limitations.

In this blog, we will explore the best methods for benchmarking private equity, the various indices and metrics used, and the limitations that investors must consider when assessing the performance of their private equity portfolios.

1. What is Private Equity Benchmarking?

Private equity benchmarking involves comparing the performance of a private equity fund or portfolio against a relevant benchmark or market index. The aim is to evaluate how well a private equity investment is performing relative to the broader market or similar funds, and to assess the risks and returns associated with the investment.

Benchmarking is crucial for private equity investors—whether they are institutional investors like pension funds or endowments, or high-net-worth individuals (HNWIs)—because it provides a reference point to measure returns, evaluate risk, and optimize investment strategies.

Unlike public market investments, private equity funds don’t have a publicly available market price that can be used for easy comparison. Therefore, investors often use specific metrics or custom indices to track the fund's performance.

2. Best Methods for Benchmarking Private Equity

To effectively benchmark private equity investments, investors need to use a combination of methodologies, indices, and performance metrics that are tailored to the unique characteristics of private equity. Below are some of the most widely-used methods for private equity benchmarking:

2.1. Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is the most common method for evaluating the performance of private equity funds. It measures the annualized rate of return on an investment, taking into account the timing of cash flows.

• Why it’s used: IRR accounts for the timing of investments and distributions, which is important for private equity because of its long investment horizon and periodic capital calls.
• How it works: IRR is calculated by finding the discount rate that makes the net present value (NPV) of all cash flows (inflows and outflows) equal to zero. The higher the IRR, the better the fund is performing relative to its invested capital.

However, IRR can be misleading if cash flows are irregular or if there are multiple rounds of funding. In these cases, modified IRR (MIRR) or adjusted IRR can be used to account for differing reinvestment assumptions.

2.2. Multiple of Invested Capital (MOIC)

Another popular performance measure in private equity is Multiple of Invested Capital (MOIC), which compares the total value of the investment relative to the capital invested.

• Why it’s used: MOIC is simpler than IRR and is a useful measure of how much value a fund has created relative to its original investment.
• How it works: MOIC is calculated by dividing the total value of the fund (realized plus unrealized value) by the total invested capital. A MOIC of 2.0 means that for every $1 invested, the fund has generated $2 in total value.

Unlike IRR, MOIC does not consider the timing of cash flows, which can make it less precise when comparing funds with different investment horizons or cash flow patterns.

2.3. Public Market Equivalent (PME)

The Public Market Equivalent (PME) is a method used to compare the performance of private equity funds to a public market index, such as the S&P 500. PME is useful for understanding how a private equity fund would have performed had the same capital been invested in public equities.

• Why it’s used: PME provides a benchmark that allows private equity funds to be compared to the broader market and helps investors gauge whether private equity is generating superior returns over public markets.
• How it works: PME calculates the value of a private equity investment if capital flows (injections and distributions) were invested in a public market index. If PME > 1, it indicates that the fund outperformed the public market index; if PME < 1, the public market index would have been a better investment.

PME is particularly useful for comparing private equity funds to public equity benchmarks, but it has some limitations, especially when it comes to differences in fund strategies and timelines.

2.4. Cambridge Associates Private Equity Index

One of the most widely used benchmarks for private equity is the Cambridge Associates Private Equity Index, which tracks the performance of global private equity funds. It is composed of a broad range of funds, providing a representative sample of private equity performance across stages and geographies.

• Why it’s used: The index includes funds from various private equity strategies (buyout, venture capital, growth equity, etc.) and is a helpful tool for understanding how a specific fund is performing compared to a broad universe of funds.
• How it works: The index provides both gross and net IRR, as well as MOIC, for private equity funds. Investors can use the index as a benchmark to compare their portfolio’s performance to the wider private equity market.

2.5. Vintage Year Comparisons

Another common method is vintage year comparison, which benchmarks a private equity fund’s performance against other funds that were raised in the same year. This is useful because funds with similar vintage years face similar economic conditions and market environments.

• Why it’s used: Vintage year comparisons help ensure that performance comparisons are made with funds that have experienced similar market conditions, making it a more relevant benchmark for specific time periods.
• How it works: Performance is compared across multiple funds within the same vintage year, allowing investors to gauge how well a fund has performed relative to its peers.

3. Limitations of Private Equity Benchmarking

While benchmarking is essential for evaluating private equity performance, it comes with several limitations that investors must consider:

3.1. Lack of Public Data and Transparency

Unlike public equities, private equity investments are not traded on public markets and therefore lack the real-time, transparent pricing data needed for precise benchmarking. This lack of transparency makes it harder to compare funds using traditional market-based metrics, especially when assessing unrealized gains.

3.2. Illiquidity and Long Time Horizons

Private equity funds often have long investment horizons, and the capital is locked in for extended periods (typically 7-10 years). This illiquidity complicates benchmarking, as returns are realized gradually and often only at the end of the fund’s lifecycle. Investors must account for these long time frames when using metrics like IRR or MOIC, as they are sensitive to the timing of cash flows.

3.3. Limited Comparability Across Different Strategies

Private equity encompasses a wide range of strategies—buyouts, venture capital, growth equity, and distressed assets—and these strategies can differ significantly in terms of risk, return, and investment approach. Comparing a buyout fund to a venture capital fund, for example, can be misleading, as they face very different market dynamics and operational challenges.

3.4. Survivorship Bias

Many private equity benchmarks, including the Cambridge Associates Private Equity Index, suffer from survivorship bias—the tendency for only the successful funds to be included in the benchmark. This can skew the performance data, as funds that failed or underperformed may be excluded from the index. As a result, benchmark performance data may not accurately reflect the true risks of private equity investing.

3.5. The Impact of Different Fund Sizes

The size of a fund can affect its performance, and larger funds may be at a disadvantage when it comes to achieving high growth compared to smaller, more nimble funds. Benchmarking across different fund sizes may not always provide an apples-to-apples comparison.

4. Conclusion

Private equity benchmarking is an essential tool for investors to evaluate fund performance, assess risks, and optimize investment strategies. While methods like IRR, MOIC, PME, and indices like the Cambridge Associates Private Equity Index provide valuable insights, investors must be mindful of the limitations inherent in these benchmarks. The lack of transparency, illiquidity, and long investment horizons are challenges unique to private equity, and these factors must be accounted for when comparing funds.

Ultimately, effective benchmarking in private equity requires a tailored approach that considers the specific characteristics of the fund, its strategy, and the broader macroeconomic environment. By using a combination of metrics and methods, investors can gain a more comprehensive understanding of fund performance and make more informed decisions.

FAQs

1. What is the most commonly used benchmark for private equity?
The most commonly used benchmark for private equity is the Cambridge Associates Private Equity Index, which tracks the performance of a broad range of global private equity funds.

2. How does IRR differ from MOIC in private equity?
IRR measures the annualized rate of return on investment, taking into account the timing of cash flows, while MOIC measures the total value generated relative to invested capital, without considering the timing of returns.

3. Why is PME important in private equity benchmarking?
PME helps compare private equity performance against a public market index, such as the S&P 500, allowing investors to understand whether private equity is outperforming traditional markets.

4. What are the limitations of benchmarking private equity?
The limitations include the lack of transparency and liquidity, difficulties in comparing different investment strategies, survivorship bias, and the long investment horizon that complicates direct comparisons.

5. How can LPs address the challenges of benchmarking private equity?
LPs can address these challenges by using a combination of benchmarking methods, including IRR, MOIC, PME, and vintage year comparisons, and by considering the unique characteristics of the fund being evaluated.