PE Returns: Benchmarks (Part II)

In our previous note, we wanted to understand what investors use to benchmark their private equity returns. For this post, we wanted to explore some of the differences between selected benchmarks and how investors make use of them for portfolio construction.

Drawing on our prior survey of over 100 US public pension plans, approximately 20% use a pure private equity benchmark (Cambridge and State Street All-PE were the most popular). As you can see, the annualized 10 year return average for the private set is materially higher – almost twice that of the public indices' average.

While private markets have consistently outperformed public markets over the past two decades – and should, given the illiquidity and leverage risk of the asset class – we wanted to drill down further on this large difference.

We deconstructed underlying sector exposures, revealing some notable differences (chart 1); namely significantly greater exposure to the higher-beta technology and highly-cyclical materials sectors. Given post-financial crisis bull markets, it’s not necessarily surprising that PE indices have outperformed consistently (chart 4), with some additional outperformance resulting from this underlying compositional difference.

Because the PE benchmarks are constructed using a private dataset, we weren’t able to perform a perfect look-through decomposition of the indices, but the aggregate figures line up nicely with Cambridge’s own deconstruction as well as Preqin total deployment data.

We exercise caution with any of the ‘public’ private equity datasets such as Preqin, Cambridge Associates, and others for several reasons: (1) inherent selection biases (in the case of Preqin, overweight mega- and large-buyout given their reliance on large public pension disclosures), (2) mixing of gross/net performance, and (3) the pitfalls of voluntary manager self-reporting. Having said that, these sources are currently the best available and we give them their due respect (Chronograph does not provide a benchmark product to avoid conflicts of interest).

Finally, we wanted to understand if benchmark preference had any measurable impact on asset allocation – are investor portfolio construction decisions influenced by choice of benchmark? This is a reasonable hypothesis if an investor's PE portfolio consistently and significantly outperforms their chosen benchmark. At least for the selected data set, the answer seems to be a fairly resounding no. The correlation between selected benchmark performance and PE asset allocation is essentially zero, as chart 3 shows.

To review the facts: About a fifth of pension plans use a PE index to benchmark returns; these benchmarks have outperformed public indices consistently, but at least part of this difference can be attributed to compositional differences. It does not appear that benchmark selection has a measureable impact on PE allocations.

In our next post, we’ll be diving deeper on the public benchmarks and what matters in selecting one. Our benchmark series is continued in parts iii) index composition, iv) leverage considerations, and v) conclusions.

Prior posts: i) introduction and lp survey.

To learn more about how the Chronograph platform helps measure far more than just relative benchmark returns, contact our team at www.chronograph.pe.