Building a better index

Private equity has become mainstream in the asset allocations of pension funds and other asset owners, but in one important way it is still a frontier market.

For such a mature asset class, the private equity market lacks a comprehensive database that can be used for creating indexes for benchmarking and other analytical tasks, or for other types of research to further the understanding of the characteristics of private equity firms.

Benchmarks and indexes are indispensable in making asset allocation decisions, and the lack of them for a particular asset class raises questions about the integrity and adequacy of any allocation.

That inadequacy is a fundamental shortcoming that must be fixed.

Unlike publicly traded securities, for which prices and fundamental data are readily available, private equity managers hold non-publicly traded investments, and their holdings, prices and performance aren't publicly shared.

Pension fund executives and others who oversee institutional assets must do more to encourage development of a comprehensive database, and private equity firms should get behind such an effort. A few already are, to their credit.

To that objective, funds and firms should embrace the project of Josh Lerner, the Jacob H. Schiff Professor of Investment Banking at Harvard Business School.

Mr. Lerner founded the Private Capital Research Institute, which is trying to build a comprehensive database to provide the raw, rich material about managers and investments. Academics, practitioners and others need such a database to better analyze the asset class, the way it performs and the way it fits into the universe of asset classes available for investment.

His project initially enlisted 15 private equity firms “not to report on the participation of a comprehensive set of firms, but rather to "start the ball rolling' with a critical mass of influential firms,” Mr. Lerner wrote in an e-mail for this editorial.

He has signed on more firms and investors since and hopes to continue to do so in the months and years ahead. “This is definitely a multiyear project,” he wrote.

The $112 billion Teacher Retirement System of Texas, Austin, the $42 billion Korean Investment Corp., Seoul, and the US$173 billion Canada Pension Plan Investment Board, Toronto, are among representatives of limited partners contributing to the effort.

In response to private equity firms' concerns about exposure, identities of the firms will be kept confidential. Still, the database “will be highly useful” to the broad pool of academics and practitioners, Mr. Lerner said.

“Clearly, private equity capital is less transparent than public equities,” Mr. Lerner said. “This effort will be a step forward ... But even in a perfect world, we will still find it more challenging to understand private equity than public equity markets.”

The challenge to build a database is daunting, and will become more so as private equity capital grows. The complexity includes data on underlying companies, vintage years of funds, distributions to investors, as well as identifying different investment strategies.

By one measure, the private equity and debt market has become bigger than the public equity and debt market.

In 2009, public offerings raised 44% more capital than private offerings. But in 2010, private equity and debt offerings in the U.S. market totaled $1.16 trillion, 8% more than the $1.07 trillion in public equity and debt offerings, according to data from a 2012 Securities and Exchange Commission report. In 2011, private offerings surpassed public offerings by 3%.

Constructing a private equity index is a complex task. Otherwise companies that create indexes like MSCI Inc. and FTSE International Ltd. would have done so. MSCI tiptoed into indexing alternatives for a relatively few years, with an index tracking hedge funds — whose underlying assets are often confidential — but it scrapped the index because of the expense of gathering data to maintain it.

Standard & Poor's Financial Services LLC in 2007 started an index of publicly traded companies that are wholly, or have significant operations, in private equity. The S&P Listed Private Equity Index is composed of about 45 companies globally.

For benchmarks, executives overseeing asset pools often use investment consultants' indexes that lack comprehensiveness and contain data only of their private equity clients. Or they will specify a certain percentage point return above a traditional index, such as the S&P 500.

Those are insufficient to provide characteristics of the private equity universe needed for rigorous benchmarking and research analysis.

“There really isn't a standard private equity benchmark,” Julia Patterson, executive director at MSCI, said in an interview for this editorial. “That is an issue with the (private equity) industry. There is no accepted standard. The market is very open.”

Creating an index “is something we are interested in,” Ms. Patterson said. But such an effort would have to resolve the issue of getting access to high-quality data that reflect the market, she added.

Mr. Lerner begins to address the issue of lack of a credible database for research on private equity. But his project doesn't include creating an index. “Nonetheless, the database should allow researchers to say much more about what drives private equity performance, as well as the relative performance of private and public markets,” he said.

Other academics or practitioners in the investment field need the database to help construct a better index than what's available now.

Those overseeing asset pools are paying high fees and internal oversight expenses for private equity management compared with traditional asset class investment management. They ought to insist on getting the type of benchmark and analysis such costs demand.

What gets measured, or measured better, gets managed better.

Mr. Lerner's project, like any such project, is a long-term effort, but at least he has started the ball rolling. n

This article originally appeared in the March 4, 2013 print issue as, "Building a better index".