Over the last 10 years, private equity has become an increasingly mainstream asset class for institutional investors. Yet measuring the effectiveness of PE investments has remained challenging because of the complex and unique characteristics of such investments.
The metrics commonly used to measure performance, such as internal rate of return, are significantly flawed and unreliable in presenting an unambiguous analysis of a private equity manager's performance. At the same time, there have been no specific industry standards or indexes in private equity investments that can be used to assess returns.
Benchmarking is most commonly used to compare the performance of a particular investment to an industrywide index. In reality, benchmarking is done at different stages of the investment process, to answer different questions. As a result, the benchmarks used should be different as well.
Initially, investors must decide 1) if private equity is an asset class that they want to include in their portfolio, and 2) the amount of capital to commit. Once that decision has been made and appropriate sectors for investment have been identified, the next process is one of manager and fund selection, and involves evaluating a manager or fund's past performance. Once investment decisions are made, an investor needs to monitor the portfolio's performance and determine any changes they would make in future investments.
Investors need a different type of benchmark at each stage of the investment process because no single benchmark can offer sound analysis for each stage. Each benchmark is appropriate in a different context.