In private equity (PE), there are more ways to calculate the alpha of a portfolio or fund than any other asset class. And in no sector other than private markets does investing in the average fund seem to go so poorly.
Should it be this way? Is the average private market fund a bad fund and the mean private market return a bad return? And if so, why?
In every other asset class, the average fund is one that hits its minimum threshold. The average fund, then, is not “exceptional.” Though, to be sure, beating a relevant index or beta reference on a rolling basis, on the key investment horizons, is hardly an easy task.
Quite some time ago, I wrote about private capital beta and internal rate of return (IRR)-alpha but the alpha narrative has still not changed. What accounts for PE beta’s poor reputation? The undeniable influence of David Swensen and the Yale Endowment Model is a critical factor.
“Yale has never viewed the mean return for alternative assets as particularly compelling. The attraction of alternatives lies in the ability to generate top quartile or top decile returns. As long as individual managers exhibit substantial dispersion of returns and high-quality investment funds dramatically outperform their less skilled peers, Yale enjoys the opportunity to produce attractive returns for the Endowment and to demonstrate that manager alpha (excess return) is alive and well.”
The Alpha Narrative, then, is about picking winners, possibly those in the highest deciles, assuming wide dispersion of returns. Too bad that PE quartiles are meaningless and that dispersion is exacerbated by the IRR’s implicit reinvestment assumption on which these concepts are based.
The Private Market’s Alpha Syndrome
Marketing will always emphasize superior returns and the alpha generated by GPs. This is widely understood and easily discounted. But what about the alpha take of allocators, limited partners (LPs), and their advisors?
Here, human nature bears much of the blame as does a combination of emotional biases and cognitive errors, which can affect the behaviors and decisions of financial market participants.
There may be the need to address the investors’ and stakeholders’ pre- and post-investment requirements — and their behavioral biases, such as anchoring, regret aversion, and illusion of control — behind the development of several measures of alpha for private market investments by allocators and advisers.
Stakeholders demand assurance and reassurance, particularly with respect to often expensive and hardly reversible investment decisions in long-term, illiquid assets. Alpha, as the ultimate outperformance seal, should meet that need.
Continue reading on the Enterprising Investor blog of the CFA Institute.