This article is sponsored by Landmark Partners and appears in the September issue of sister publication Private Equity International
Landmark Partners and New Mexico Public Employees Retirement Association are seeking to fill a gap in the industry by creating a measure of performance above or below a benchmark in currency terms. They see this as a useful tool for limited partners looking to select fund managers that can outperform comparative public market benchmarks and for LPs and GPs alike who want to gear performance fees more towards relative returns than toward absolute performance, as does traditional carried interest.
The new measure can be particularly interesting within the secondaries market, since secondaries managers tend to work with broadly diversified portfolios that can be more readily compared to public market alternatives, according to managing director Avi Turetsky, who works in Landmark’s quantitative research group.
What prompted Landmark to explore a new performance measurement methodology?
It started with a conversation that we had with some of the team members from NM PERA. The question ‘could we measure the outperformance of a private market investment in dollar terms?’ came up. There are good methods out there for measuring the performance of a private market investment relative to a benchmark both as a multiple and as a rate. But there was no way that we knew of to precisely measure outperformance in dollars.
I should also mention that a key purpose of Landmark’s quantitative research group is to come up with new tools and new processes that can be useful for us and for the LPs and GPs we work with. Just as a matter of our normal course of business, we receive calls quite frequently from LPs and GPs who present problems and ask us to help them think about solutions.
Why is it important to be able to measure the outperformance of GPs in dollar value?
Having a measure like that is useful for performance evaluation and also potentially for compensation. For performance evaluation, it can be useful for an LP to know how much dollar profit a manager creates above what that LP could have received if it put its money in a public market alternative and also how those dollars are paced over time.
“With the excess value method, there’s a way to actually calculate in dollars how much more a manager delivers compared to a public market alternative”
It’s also useful to be able to calculate the outperformance in dollars because it makes it possible for an LP to compensate the GP based on the value they create in excess of public market benchmarks, rather than compensating them using a carried interest arrangement.
Carried interest compensates a manager for its entire absolute return regardless of what the public market does. For example, if I invest in a diversified private equity manager and that manager produces a 15 percent return, I will typically pay them 20 percent of that entire gain even if similarly diversified public markets, at the same time, achieved the same 15 percent return. What excess value enables you to do is to create a compensation arrangement where an LP doesn’t have to pay just for getting a diversified portfolio of companies, because the LP can get that in the S&P 500 or similar broad benchmark. The LP might only want to pay the manager to the degree that the manager can beat that benchmark. With the excess value method, there’s a way to actually calculate in dollars how much more a manager delivers compared to a public market alternative.
I would also anticipate both practitioners and academic researchers will use excess value to answer questions such as, how much value have different private equity managers created over time? What do those patterns look like? How do large managers compare with smaller managers?
What makes EVM particularly useful for a secondaries firm like Landmark?
One of the really interesting things about secondaries providers is that we are able to build a very diversified portfolio within private markets. A primary GP might have 10 or 15 companies in a portfolio. A secondaries manager might have 500 or 2,000 companies in a portfolio. That means that the types of quantitative tools that are used in public markets and concepts such as alpha and beta and factor exposures become very relevant in secondaries. That’s probably a large part of why you’re seeing a tool like this coming out of a secondaries firm like Landmark.
We can use a tool like the excess value method in two directions. First, we can use it to evaluate managers that we’re considering investing with and funds we’re considering buying. Excess value can help us paint a picture of how they create value over time. Second, we can also use it with LPs who invest in us, to measure how we create value over time. Excess value is relevant throughout private markets, but because of what secondaries do in the market, this type of tool is particularly interesting for a secondaries firm.
What are some of the limitations of other performance methods that already exist?
There’s a measure called KS PME that dates back to 2005 and was created by two academics, Steve Kaplan and Antoinette Schoar. It measures private market outperformance as a multiple. KS PME multiple is the future value of the distributions from a private market investment divided by the future value of the contributions had they been invested in a public market benchmark.
“Excess value basically takes direct alpha and KS PME as starting points and adds the adjustments needed to transform them into dollar measures”
There is a strong intuition that many people have that you can calculate outperformance in dollars simply by taking the numerator of that equation minus the denominator. It turns out that does not work if the investment has multiple distributions. Let’s say there is one distribution at year five and another at year 10. When you future value distributions at year five to year 10, you’re either rewarding or penalising the manager for what the market does after the manager has already returned the capital to investors.
There’s also a rate method called direct alpha, which was created in-house at Landmark back in 2009, which measures the private market outperformance as a rate. What direct alpha tells you is by how much, as an annualised percentage, did the private manager beat the public market benchmark. It turns out that it’s not straight forward to translate that rate into dollar terms either and for the same reason.
What was the research process that led you to EVM?
Almost everyone we spoke with about this initially had the idea that you can just take the future value KS PME numerator minus denominator. As we started modelling cashflow streams, we realised that this intuition does not work and the reason was pretty clear: interim distributions. Then we tried to figure out how we can start with the basis of direct alpha and KS PME but get to something that would only reward or penalize the GP when capital is at risk.
The excess value method builds on the same principles as direct alpha and KS PME. What excess value basically does is it takes direct alpha and KS PME as starting points and adds the adjustments needed to transform them into dollar measures.
Do you anticipate EVM will eventually supplant carried interest to measure performance compensation?
I don’t think that next year everyone in the market is going to move to being compensated this way, but I do think there is a good chance a certain group of LPs, who really believe in the idea of selecting managers for alpha production, will want to pay managers specifically for outperformance. Excess value lets them do that. I believe there will also be some group of GPs who believe they are high alpha producers and will be more than happy to accommodate that LP request.
How can LPs start using EVM?
As an LP, to calculate excess value, you need to know what the cashflows in and out of the private market investment are. You also need to know what the values over time of the private investment are. If you can get that information, you can calculate excess value. We’re being very open about how it’s being calculated.
At Landmark, the excess value method is a tool that we’re going to be adding to our toolbox. As investors, we also want to know how the excess value is created over time. It’s really a matter of whether you can get the data. We have an Excel tool we have created to calculate excess value which we can also make available upon request.
What feedback have you received from LPs and GPs?
The feedback we’ve received, especially from LPs, is that the excess value method is a really interesting idea. LPs are asking us to walk them through the process of calculating excess value. A number of LPs have expressed that excess value looks attractive from a compensation perspective since it can enable them to pay managers only for their outperformance. You also have LPs who say it looks interesting, but they don’t see excess value becoming the dominant method for calculating compensation in the industry just because carried interest is so well understood and widespread. I’ve heard both of those viewpoints. There may also be investors who don’t think of private markets relative to public markets, though we certainly do. Ultimately, we think there will be some LPs who are eager to adopt it, but others who will not.
Excess value-based compensation also has the potential to have quite a meaningful advantage for certain GPs. If a manager creates alpha, that manager can end up being paid more under the excess value method than under traditional carried interest. If the public market is flat for 10 years and a manager returns 7 percent, under carried interest, that manager probably gets paid nothing because of not hitting the preferred return. Under excess value, that manager would be paid potentially substantially for having outperformed the public market by 7 percent.
In the same way, even if the public market does well, if a manager can outperform the public market by a large amount, depending on the arrangement, that manager can make more under excess value than under carried interest. Excess value is also potentially a way for GPs to diversify their income streams. If a manager is consistently alpha producing, under excess value, that manager can have a revenue stream that’s more stable.