Times are tough in private markets. High borrowing costs are hurting returns, managers are struggling to exit investments, and regulators are circling. This has reignited a long-standing issue: the challenge of accurately measuring performance in these opaque holdings.
Barry Griffiths, a leading quantitative analyst, is at the forefront of developing an alternative method for evaluating unlisted investments. His approach aims to demystify private markets, including buyout funds and venture capital, enabling investors to compare returns across asset classes and assess the true value added by managers.
Key Takeaways
High borrowing costs and regulatory scrutiny are impacting private market returns.
Barry Griffiths is pioneering a new method called "direct alpha" to measure performance.
Direct alpha compares cash flows from private investments to public equity benchmarks.
The method reveals that many funds may not be generating as much value as previously thought.
Institutional investors are increasingly adopting direct alpha for better insights.
The private equity sector commanded a staggering $10.6 trillion in 2023, with projections suggesting it could grow to $25.1 trillion by 2033. However, understanding the risks associated with these investments remains a challenge. Griffiths notes that the lack of transparency in private markets has limited the number of systematic investors and analysts in the field.
The direct alpha approach compares cash flows—both contributions and distributions—against what those funds would have earned if invested in a public equity index during the same period. This benchmark could be a broad index like the S&P 500 or a more specific industry gauge. The results provide insights into how much value a fund has added or lagged behind the market.
In a recent study, Griffiths and his colleagues analyzed over 2,400 buyout funds. They found that while the average reported internal rate of return (IRR) was 12.3%, the direct alpha was only 3.1% when compared to a broad market benchmark. This suggests that while some funds may show strong absolute returns, they may not be outperforming the market significantly.
The direct alpha method shares similarities with the Kaplan-Schoar measure but presents results as an annualized percentage, aligning more closely with investor expectations. Griffiths, who has been influential in this field, has seen his protégés begin to spread the direct alpha methodology throughout the industry.
Despite the challenges facing private equity, investment continues to flow in, with record levels of committed cash awaiting allocation. Many institutional investors view private assets as essential for diversified portfolios, leading to a growing interest in the insights provided by direct alpha.
However, not everyone in the industry is enthusiastic about these new methods. Traditional private fund managers often base compensation on absolute performance, which can create resistance to adopting a more rigorous analytical approach. Critics argue that investors primarily care about absolute returns and may be reluctant to accept that their perceived stability in private markets could be misleading.
As the demand for transparency in private markets increases, major players like BlackRock are investing in data providers to enhance their analytical capabilities. The journey to fully understanding private asset performance is ongoing, but the efforts of analysts like Griffiths are paving the way for a more informed investment landscape.
In conclusion, as competition intensifies and market pressures mount, the adoption of innovative methods like direct alpha may reshape how private market performance is evaluated, ultimately benefiting investors seeking clarity in their investment decisions.
Sources
Wall Street Math Wizards are Decoding Private-Market Returns, Mergers & Acquisitions.