(Bloomberg) — Times are tough in private markets. High financing costs are hurting returns, managers are struggling to exit their investments and regulators are circling. All of this brings back a problem that has long dogged these opaque companies: no one knows exactly how to actually measure their performance.
Barry Griffiths is among a small group of quantitative analysts who are trying. He is the driving force behind an alternative method for measuring unlisted investments that he says has the potential to demystify the world of private markets, from buyout funds to venture capital. It is claimed that it will help investors compare returns with those of other asset classes, while revealing the true value that managers bring to the company.
That’s a controversial prospect in an industry known for doing its own homework in terms of performance and awarding itself generous pay based on the results. Not to mention that successfully decrypting such illiquid investments is fraught with pitfalls, as anyone who modeled mortgage bonds and derivatives before the financial crisis will likely testify. Still, the rewards of success can be enormous: Private equity was worth $10.6 trillion in 2023 and is expected to grow to $25.1 trillion by 2033, according to Bain & Co. estimates.
“It’s not easy to understand the risks you face,” says Griffiths, a former chief quant at private equity giant Ares Management. The lack of transparency is one reason why systematic investors and analysts like him are few and far between in the industry, as the data they rely on is scarce. But as competition increases and market pressure increases, quantitative ideas are gaining traction – particularly ‘direct alpha’, the approach pioneered by Griffiths and his colleagues.
Alpha – a measure of a portfolio manager’s performance above the broader market – is a well-known concept in the financial industry. It has become a common tool in stocks, where indexes like the S&P 500 provide an obvious benchmark for performance. A huge amount of capital shifted to low-cost, passively managed funds, at the expense of human stock selection, after it became clear that few managers consistently achieve alpha. It would take much more sophisticated statistical work to do something similar in the private markets, where valuations are rare and largely determined by fund managers.
Private investments have cash flows that can be measured. But because each fund takes money and pays it back at different times, it’s hard to really understand performance.
The direct alpha approach compares these cash flows (both contributions and distributions) to what the dollars would have been worth if they had been invested in a public stock index during the same period. That benchmark could be a broad benchmark, such as the S&P 500, or perhaps a gauge for stocks in the same sector in which the fund invests. The comparison should tell you how much you earned above the market, or how much you underperformed. “We often found that someone with great absolute returns happened to be investing in the right sector at the right time,” says Griffiths.
In a study published in 2023, he and co-authors Oleg Gredil of Tulane University and Ruediger Stucke, head of quantitative research at private equity firm Warburg Pincus, conducted a direct alpha analysis on a database of more than 2,400 funds that specialize are in buyouts. Their average reported internal rate of return (IRR) – the annual growth rate based on a fund’s cash flows – was 12.3%. But how does that compare to other investments? The researchers found that the funds’ direct alpha was 3.1% based on a broad market benchmark and 1.7% based on sector indexes.
Those are still good numbers, but for many investors it may be too small a reward for locking up cash in illiquid and often leveraged assets for long periods. The average also obscures a notoriously wide range of outcomes. Meanwhile, VCs fared even worse using this lens, with an average alpha of zero compared to comparable publicly traded stocks.
Direct alpha shares DNA with another well-known measure, the Kaplan-Schoar private market equivalent, named after Steven Kaplan and Antoinette Schoar, the economists who developed this measure. The key difference is that direct alpha displays results as annualized percentages, which is closer to how investors typically think about performance.
Griffiths published his first paper on direct alpha while working at Landmark Partners, a secondary private equity investor later acquired by Ares. He quit the company last year. His successor, Avi Turetsky, calls Griffiths “the godfather” of private market quants. Now a small group of his Landmark protégés are quietly spreading direct alpha further through the industry.
Among them is Ian Charles, managing partner at Arctos Partners, which has a strategy that provides capital solutions to private equity managers. (Arctos has brought in Griffiths as an adviser.) One manager came to Charles with the idea of launching a fund focused on a sector where it had delivered excellent returns. “It turns out that a lot of companies with pure-play products in that sector have great IRRs,” says Charles. But alpha analysis told a different story. The company’s actual alpha generation – the value it added – was “indistinguishable from zero” after adjusting for compensation and broader industry performance, and its strength actually lay elsewhere, he says.
Despite the recent problems in private equity, money continues to flow in, while record levels of committed cash still need to be allocated to investments. There is a growing belief among many large institutional investors that private assets are an essential part of diversified portfolios. Against that backdrop, the added insight of direct alpha influential fans wins. Japan’s $1.6 trillion Government Pension Investment Fund uses a version of it in combination with more established analytical tools. Norges Bank Investment Management, which manages Norway’s $1.8 trillion sovereign wealth fund, used the method when considering whether to enter the asset class.
It is unlikely that everyone will be equally enthusiastic about these new insights in an industry where private fund managers are typically rewarded based on absolute performance. In a 2021 paper, Griffiths, Turetsky, and other co-authors laid out a way to calculate private market alpha in dollars. It would, they wrote, “allow performance compensation to be paid only for outperformance against a public market benchmark.”
Direct alpha is “certainly not a standard way” to look at performance, said Hugh MacArthur, chairman of Bain’s private equity practice. He says investors care about two things: absolute returns over time and whether it is repeatable. “People try to torture the data and say, ‘Well, the returns aren’t really what you think they are,’” MacArthur says. But at the end of the day, “the money goes in, and whatever comes back, I look at it and I measure it and it’s more, so what am I going to do? Denying that it is more and not doing the rational thing?
Virtually any attempt to bring statistical rigor to private markets—where the academic literature is replete with conflicting findings—is destined to be controversial. A common limitation is that any measurement is only as good as the assumptions that need to be made with it. The choice of benchmark makes a huge difference for immediate alpha results. A recent study from money management firm Dimensional Fund Advisors found that while the average buyout fund beats the S&P 500 over its lifetime, it actually loses to an index of small-cap value stocks — which some say looks more like a typical private equity portfolio. .
Private equity returns are also vulnerable to the influence of managers because, among other things, they can control the timing of cash flows into and out of their funds. This can affect direct alpha calculations, but not as much as with absolute returns. “My group tended to do a lot of sensitivity analysis because we were aware that we were very uncertain,” says Griffiths.
Large investors may even have an incentive not to look too carefully under the hood of returns. The apparent stability of prices in private markets – such as in 2022, when the MSCI World Index of equities lost 19% and an MSCI measure of PE funds fell only about half – could be beneficial to investors looking to demonstrate that their portfolios carry less risk. But some of this stability may be an illusion created by the fact that private assets are not traded or priced as frequently as public equities. Cliff Asness, co-founder of quantitative asset manager AQR Capital Management, sees this as a deliberate ploy he calls “volatility laundering.”
In a study this year, Mark Anson, chief investment officer of the $29 billion Commonfund, which invests money in nonprofits and others, found that the volatility of large buyout funds nearly doubles to 21%, far higher than that of the S&P 500, if you take into account, lags behind in reporting valuations. Traditional private market reporting methods don’t tell you “the true economic story,” he says. For Anson, who previously led the California Public Employees’ Retirement System’s push into private equity, smoothing out returns and calculating alpha has given Commonfund a higher allocation because it can be more certain of the risks it takes.
It’s a similar story at the $43.4 billion UPS Pension Plan, where senior portfolio manager Alexander Dorf says the use of direct alpha has boosted the plan’s performance in private assets and driven a shift from large managers to smaller, more specialized managers. He thinks these methods will work. As it becomes harder to ride bull markets, “you’re going to see more of these debates about what the purpose of PE is,” he says. “Is it really just a reduction in volatility, or are there actual improvements?”
Meanwhile, some of the biggest players on Wall Street are developing their own tools for assessing private markets. Asset management giant BlackRock Inc. buys Preqin, an alternative asset data provider, for $3.2 billion to help it index private markets. “There is a big gap in the transparency of private assets versus the public markets,” BlackRock Chief Operating Officer Rob Goldstein told analysts after announcing the deal. “If you can’t analyze an investment properly, you don’t understand it.”
Yet the path to a full explanation of private asset performance is likely to be long. The earliest stock market figures laid the academic foundation for alpha in stocks in the 1960s, but index funds only really took off after the global financial crisis. “I’d like to see more information get into the hands of practitioners, and I think that’s starting to happen,” says Griffiths. “It’s just slow. Everything in private equity moves slowly, right?”
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