By Matt Curtolo, CAIA
The world is replete with relative comparison. Certainly, in our social lives, we are often ‘keeping score’ of our ‘performance’ when compared to others. In 1954, psychologist Leon Festinger developed the theory of social comparison, which is the idea that individuals determine their own social and personal worth based on how they stack up against others.
This is no different than the world that I have lived in for the last two decades. In private equity, however, relative performance is still one of the biggest puzzles and most challenging exercises. So why, then, have we as an asset class tied ourselves to a single measure – a ‘quartile ranking’ – as a primary indicator of good and bad?
What’s My Motivation?
First, think about a private equity manager and the compensation structures they operate under (and the ones that we, as investors, accept). For a manager to earn coveted carried interest, what do we, as LPs, measure them against? Do we say, if you aren’t top quartile, you don’t get paid? Of course not. The managers themselves have no control over how their peers do. Beyond that, private equity is not an asset class where everyone fishes in the same small pond. The PE universe is vast, with approximately 6 million ‘employer firms’ in the US (meaning at least one paid employee other than the owner), and approximately 140,000 companies with revenue over $1 million. This doesn’t even consider net new companies that are being created by entrepreneurs and innovators on a daily basis. Because of that, this is not a zero-sum asset class. Everyone can find their own niche, do something a bit different, and generate their target performance. If they can generate performance over and above a pre-determined absolute level, they can share in the profits. And make no mistake, most managers are motivated by that simple fact. Of course, ego runs high, so I’m not naively saying these groups don’t care about how they perform relative to peers, only that they don’t (and can’t) manage to that figure. It’s largely unknown and is a loser’s game.
So maybe the purpose of a quartile isn’t to measure the manager, but to measure the allocator. Were you able to pick the best manager relative to their (mysterious) peer set? It seems like a reasonable enough exercise and a framework we know well from public markets. However, this assumes that all investors have access to the same opportunities at all times. Unfortunately, the world is not created equal. Private markets are still largely inefficient, and the act of sourcing funds and building a complete market map is challenging, bordering on impossible. In addition, many funds included in the peer sets are not open to new investors. Beyond that, other investors might simply be excluded from participation due to characteristics of their organization, be it disclosure, structure, size, etc. It strikes me as an unfair assessment of someone’s relative skill if they don’t have equal access due to things outside their control.
The other confounding part of our reliance and weight on quartiles is that there is no single source of truth. As an industry, we’ve made tremendous strides to become less opaque, and there are now several data providers that LPs can choose from to assess relative performance. The challenge is the lack of completeness and uniformity. The methodology, collection, and vetting of underlying returns vary by provider, leading to different outcomes from each universe. Some are black box approaches, some rely on public disclosure from public investors, and others allow for self-submission, but in the end, none are right, and none are wrong. They are all valuable data points, but this inconsistency allows the GP to pick and choose where they rank themselves, and they inevitably choose the most favorable ranking. Several research studies have pointed out that more than 75% of the market can claim top quartile status based on one of the major universes, using one or more of the primary performance metrics (with some latitude to define vintage year as well).
Only a Small Slice of the Universe
The other and perhaps more direct challenge is that these universes are not reflective of the entire market, only a small subset. We often cite publicly available information from Pitchbook, one of the leading data providers in private markets. For example, the 2024 Pitchbook-NVCA Monitor provides transparent totals for funds raised in a given vintage year for US venture capital. When comparing this number to the funds included by the major private market performance data providers in their vintage year performance, the average ‘coverage ratio’ from 2014-2023 is around 24%. The means more than three-quarters of the funds raised are not captured by the universe providers.
In spite of how imperfect this might be, it’s something that many in the industry call a ‘benchmark.’ Unfortunately, these so-called benchmarks (I prefer to call them universe comparisons) fall short of nearly every test (suitability, pre-specification, investability, measurability, unambiguity, et al.) outlined by the CFA Institute for what constitutes a valid benchmark.
I’m not saying to throw out relative performance or quartile rankings, but to use them with extreme caution and not as a singular assessment of good and bad. For example, I recently reviewed a fund with strong absolute returns, but it was in a vintage year with only 11 funds represented in a particular universe. This fund ranked it in the 3rd quartile — but the real question is, should I care? Does that 11-fund universe tell me anything about the manager in question and their ability to generate returns? The headline of ‘3rd quartile’ will inevitably be a cause for concern for many LPs, even though it is not at all indicative or reflective of that manager’s ability. Over the last 20 years, I’ve spent countless hours trying to engineer a better mousetrap. The dawn of PME comparisons and all the variations we now have are helpful, especially in asset allocation models. Still, many don’t view public equities as their guidepost or alternative.
So, what does that leave us?
In truth, it leaves us with a back-to-basics model, to the roots of how our managers are compensated. Private equity began as an absolute return asset class, and I think we need to remember that. We need to set realistic targets for managers, have terms that reflect that expectation rather than an antiquated cost of capital assumption, and assess them on and hold them accountable for the only thing they can control — their own performance.
The same goes for assessing an allocator. Select a realistic, target long-term return. The derivation of that number will likely be institution-specific, based on their own needs. Once that number is decided, stick with it. If desired, set interim checkpoints based on capital deployment or the length of holding period. It is essential to measure progress towards that goal on a regular basis but also to keep in mind that the asset class is not meant to deliver that return in a short period.
As innovations continue in private markets transparency and analytics, let’s hope that someday we can find a universal ‘benchmark’ to conduct relative comparisons. Until then, let’s focus on measuring managers and allocators based on things that are known and within their control.
About the Contributor
Matt Curtolo, CAIA is an experienced allocator with experience across all areas of alternative investments. Most recently, he served as Head of Investments at fintech start-up Allocate, with prior leadership roles at MetLife and independent OCIO Hirtle Callaghan. Matt currently holds several advisory positions that span start-ups, asset management firms and fund of funds. He also manages his own advice practice, providing GPs with strategic guidance on strategy, fundraising and investor relations.
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