Private equity has firmly established itself as a key component of global investment portfolios. With assets under management (AUM) expected to more than double in the coming years, the sector is on track to witness rapid expansion. Notably, the secondaries are anticipated to exhibit the highest annualized growth during the forecast period of 2023 to 2029¹.

Unlike public markets, where standardized indices such as the S&P 500 or MSCI World provide straightforward performance tracking, private equity operates without universal benchmarks. This creates an urgent need for robust indices and benchmarking tools to deliver transparency and enable meaningful appraisal.

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Why Private Equity Needs Benchmarks

The increasing demand for higher returns and diversification has driven a surge in private equity investments. With global AUM in alternative investments expected to grow at an annualized rate of 9.7% until 2029¹, institutional investors require standardized performance tracking methods to compare private market returns with public markets.

Furthermore, as private markets continue to attract institutional and retail capital, regulatory authorities are calling for heightened transparency. This intensifies the need for standardized performance measurement tools, positioning benchmarks and indices as vital instruments for compliance and trust-building.

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Challenges in Establishing Benchmarks

Despite their importance, developing benchmarks for private equity presents unique challenges:

• Limited Transparency: Unlike public markets, private equity is characterized by limited visibility, complicating efforts to gather comprehensive performance data.
• Variety in Strategies: The diversity of private equity approaches, from buyouts to venture capital, makes it difficult to create universally applicable benchmarks.
• Timing Considerations: Performance metrics such as Internal Rate of Return (IRR) are highly dependent on cash flow timing, reducing their comparibility across funds with differing life cycles.

Decoding Indices and Benchmarks

Indices: Indices aggregate data to represent the overall performance of specific sectors or asset classes, offering a snapshot of market trends. For instance, in public markets, indices like the S&P 500 track the performance of top publicly listed companies in the U.S., weighted by their market value. In private markets, indices such as Preqin’s Private Capital Indices measure the quarterly performance of closed-ended private capital funds across six asset classes, including private equity, venture capital, and infrastructure. These indices provide a macro-level view of private market trends and are built on data from over 14,500 funds, reflecting a market capitalization of more than $11.3 trillion².

‍Benchmarks: Unlike indices, benchmarks are customized tools used to assess the performance of specific funds or portfolios relative to comparable peers. They account for variables like investment strategy, geographic focus, and fund size, enabling detailed performance comparisons. For instance, limited partners (LPs) often use benchmarks to evaluate whether their investments meet risk-return objectives, while general partners (GPs) highlight competitive results in their marketing efforts.

In private equity, performance is typically measured using internal rate of return (IRR), a widely recognized metric for assessing profitability over time. Popular benchmarks for U.S. and European private equity include those developed by Cambridge Associates, Preqin, and MSCI. Additionally, the public market equivalent (PME) approach provides a framework for comparing private equity IRRs to returns from public indices like the S&P 500 or MSCI World Index, offering context for private equity’s relative performance. 

Key Considerations for LPs in Fund Performance Assessment

‍According to Preqin’s latest guide to Private Capital Indices and Benchmarks, LPs have two main considerations when assessing fund manager performance²:

1. Choosing the right benchmark constituents
2. Defining performance metrics ^‍‍

Selecting Benchmark Constituents

‍One of the primary challenges in constructing a benchmark is ensuring a balance between two critical aspects:

• Ensuring the selected funds share enough similarities to allow for meaningful comparisons.
• Including a sufficient number of funds to make performance assessments statistically significant

To maintain comparability, funds within a benchmark should generally have matching characteristics such as vintage year, investment strategy, and geographic focus. Investors may also apply additional filters, such as sector exposure or fund size, to refine peer group comparisons. A commonly used approach is to rank the peer group based on return and calculate the average for each 25% of the group from top to bottom. This allows you to identify where a selected fund fits in terms of quartile return and to identify if it’s a ‘top-quartile performance,’ second, third or if its in the bottom-quartile.

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Determining Performance Metrics

Private capital performance is usually assessed using a combination of different return measurements:

• Internal Rate of Return (IRR): A time-adjusted metric that captures the annualized return of a fund.
• Money Multiples: Includes key ratios like Total Value to Paid-In-Capital (TVPI), which measures total returns on invested capital.
• Distributions to Paid-In-Capital (DPI): Measures how much capital has been returned to investors relative to contributions

By integrating robust indices and benchmarks, private equity stakeholders can navigate complex market dynamics with greater confidence, ensuring that their strategies align with both market trends and long-term objectives. 

The Road Ahead for Private Equity Performance Measurement

‍As private equity continues to expand, the demand for effective performance evaluation tools is only expected to grow. Indices and benchmarks are critical in fostering transparency, consistency, and comparability. By advancing benchmarking practices, the private equity sector can enhance investor trust, paving the way for sustainable growth and innovation.

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Author

Saad Adada, CFA

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_Sources:

_{1-https://www.globenewswire.com/news-release/2024/09/18/2948056/0/en/Global-alternatives-markets-on-course-to-exceed-30tn-by-2030-Preqin-forecasts.html?utm_source=chatgpt.com}

_{2-https://www.preqin.com/insights/research/reports/the-preqin-guide-to-private-capital-indices-and-benchmarks}

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