What is private market benchmarking and why is it important?

Private market investments have the potential to outperform public investments and play a key role in most institutional investor’s allocation strategies. However, private market fund performance data is not widely available, nor subject to the same regulatory codes as public alternatives which provide for robust data reporting and transparency.

While public investments use widely agreed upon benchmark criteria and indexes—like the S&P 500 and Dow Jones Industrial average—investors often face challenges in trying to understand and benchmark the performance of their private market assets.

In this post, we dive into private market benchmarking, discussing some of the strategies for understanding the performance of private market funds along with common performance metrics like horizon IRR.

What is private market benchmarking?

Private market benchmarks are standards against which investors and other private market professionals can compare the returns of a fund to the returns of its peers. Benchmarking provides a way for limited partners (LPs) and general partners (GPs) to gauge the performance of an individual fund in relation to its peers and evaluate broader performance across asset classes.

Through leveraging robust benchmarks, LPs can avoid missing important investment opportunities or making poor allocation decisions, and GPs can streamline their fundraising efforts. In the private markets, fund performance is usually benchmarked against a set of peer funds with similar attributes, such as fund size, vintage year and geography.

How is evaluating the performance of public and private market funds different?

Private market funds are based on different strategies and are structured for entirely different return profiles compared to public market funds. Because of that, they face a distinct set of challenges, and it is therefore especially important to consider alternative metrics when evaluating their performance. Private market funds require benchmarks that consider things like longer time horizons, extended lock-up periods and less liquid fund structures.

What fund attributes make up a standard private market benchmark?

Some of the most common attributes to consider when creating private market benchmarks are fund size, vintage and geography and fund type.

Fund size is important to account for in benchmarking because it impacts portfolio construction as well as the size and timing of cash flows, and different sized funds will have varying characteristics. For example, larger funds may have an outsized effect on an overall set of benchmarks if funds were not grouped together.

A fund’s vintage—or the year it makes its first capital call—is another important attribute to consider in private market benchmarking. Typically, funds are grouped by vintage to control for time. For example, funds that share the same time frame will have been exposed to similar economic conditions, which helps make for a more accurate comparison.

Fund type, such as VC, PE, real assets and debt, is also important to consider. D.ifferent strategies will employ different approaches to portfolio construction and make investments in significantly different targets with varying risk/return profiles.

For example, a VC fund will invest in relatively newer, up-and-coming companies while a PE fund will invest in larger, more established companies. Further, a VC fund may be more likely to invest in a wider number of portfolio companies and call down capital more frequently.

Fund type can be further broken out to include more specific classifications within asset classes. Here is a table showing some fund types that PitchBook tracks. Though we don’t signify additional classifications for fund of funds or secondaries, we still measure them as distinct groups.

*The PitchBook Benchmark report series does not currently include specific venture capital classifications, while the platform does track them.

What is the process for benchmarking private market funds?

Most commonly, benchmarking private market funds involves looking at granular fund performance metrics such as, horizon IRR, cash flow multiples and hurdle rates that are calculated from a data set of underlying funds within a certain peer group. Here we zoom in on some of the most used private market benchmarks.

What is the internal rate of return (IRR)?

Internal rate of return is a go-to metric used in the private market community to measure a fund’s overall performance.

An IRR benchmark is especially useful for private market funds as it includes the timing of cash flows, such as when capital is called down or deployed. The efficient use of uninvested capital (as well as invested capital) can significantly impact overall returns and is important to track, particularly considering a closed-end fund structure. The technical definition is that it represents the rate at which an historical series of cash flows are discounted so that the net present value of the cash flows equals zero.

Here’s what the formula looks like:

Where: CF0 = Initial Investment / Outlay CF1, Cf2, CF3, .... CFn = Cash flows N = Holding period NPV = Net Present Value IRR = Internal Rate of Return

What is horizon IRR?

Horizon IRR is a metric that shows the IRR for a specific range of time. For example, a 1-year Horizon IRR will look at IRR over the period of one year, a 3-year Horizon IRR will look at three years and so on. This is helpful to measure as it can highlight differences in performance across funds’ lifecycles.

What is public market equivalent (PME)?

A public market equivalent is a calculation used to compare private market fund performance to a given public index. This metric accounts for irregular cash flows by calculating equivalent investments in a public market benchmark using the timing of a private market fund’s capital calls and distributions. It’s designed to give investors more of an apples-to-apples comparison between private market funds and public benchmarks. It’s important to avoid confusing PME with public or private comparables, which are used to assess the value of a company.

What are cash multiples (DPI, RVPI, TVPI)?

Cash multiples provide a relatively easy way to gauge the scale of a given fund’s returns. Each multiple compares an aspect of a fund’s value to capital that’s already been called down or “paid-in.” For example, these multiples include capital that is distributed back to LPs (DPI), the remaining unrealized value of a fund (RVPI) and the overall realized and unrealized value of a fund (TVPI).

• DPI stands for Distributions to Paid-In and represents how much value has been returned to LPs relative to how much capital has been called by a GP. Also called the realization or cash-on-cash multiple, this measure is helpful for seeing how much a fund is paying out. Generally, higher DPI is preferable as it shows that a GP is able to return more capital (e.g. a 2.0x DPI means that two times the amount has been returned compared to the amount paid-in).
  
• RVPI stands for Remaining Value to Paid-In and represents how much unrealized value remains in a fund relative to what’s been paid-in. This multiple can help track a fund’s market value through the net asset value of unrealized assets. As a fund ages and investments are exited, RVPI will continue to decrease towards zero.
  
• TVPI stands for Total Value to Paid-In and represents the combined realized (DPI) and unrealized (RVPI) value of a fund relative to paid-in capital. As the name suggests, it shows the overall value of a fund compared to its cost (a higher TVPI would indicate higher value).

What is a hurdle rate?

A hurdle rate is the rate of return (above return of capital) that a GP must return to its LPs before taking any profit. It is measured as a percentage.

What additional benefits do PitchBook clients get from PitchBook Benchmarks?

PitchBook clients get full transparency into the underlying funds that make up each benchmark, all of those individual funds’ return histories and even the investments made by those funds, providing them with the insight they need to construct accurate benchmarks that fit their needs. Plus, PitchBook also provides built-in pivot tables that allow users to easily identify hurdle rates for peer groups.

In addition to access to the PitchBook Benchmarks report series, the PitchBook Platform offers clients the ability to create benchmarks with custom peer groups based on criteria of their choice (including portfolio construction and industry).

More about private market benchmarking

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