The Duration Makeover of Private Market Performance Measurement

By Massimiliano Saccone, CFA, Founder & CEO, XTAL Strategies

For many years, the definition of private market performance seemed inevitably reduced to hazardous time-weighting approximations. The calculation hurdle of the presence of interim cash flows looked insurmountable, so much so that, in the private markets, it became perfectly acceptable to neglect the basic rules of performance analysis and comparison.

Critical conditions like the self-financing constraint, hence the consistency (or lack thereof) of the reference notional capital in any compounding exercise from period to period, and the key requirement of the preliminary determination of a target time horizon, have become irrelevant under the shadow of the IRR reinvestment assumption (also pervasively permeating all public market equivalent and alpha measures).

Given current private market information standards, it’s been common to have the fast-thinking impression that an investment turning capital over 3 years to generate a 20% return (that’s most likely an IRR), in spite of drawing only 70% of the commitment, is better than one of the same vintage delivering a 15% return (again, most likely an IRR) over 5 years on 100% of the commitment. It certainly shows up at a higher quartile rank. 

Everyone is reminded of the fact that, in the private markets, more than one metric should be used to handle ambiguity. But that is not the case in all other asset classes, where time-weighted standards provide an unbiased possibility of comparison and imply that a 15% return would pay a 7% pension annuity over a given time horizon and a given amount of capital. That is not necessarily the case with a 15% IRR. Why can’t there be a better, more representative method for private markets performance measurement?

The unconventional fixed-income parallel

Perhaps the traditional dominance of IRR in individual private equity transactions (and the related NPV calculations) has shaped the development of aggregated private market metrics into their current form. Clearly, there was no suggestion that a solution to the measurement problems of private equity could be provided by fixed-income methodologies. No fixed-income-like return seemed to properly depict private equity returns.

In fact, it is not the type of returns but the structure of the cash flows of fixed income securities that should have inspired a different approach to private markets performance measurement. The fixed income universe embraces a diverse group of obligations, with structures well beyond basic treasuries that also include asset backed securities. While most securities have regular interim cash flows and are perceived to be low risk, and a few don’t have any interim cash flows (hence denominated zero coupon or zeroes), asset backed securities, mortgage bonds, and collateralized obligations may have aleatory cash flows, principal prepayment optionality, and potentially yield high risks. Indeed, private market funds resemble asset-backed securities, even if the pool of the underlying assets is not usually purchased at time zero. 

The duration pivot

Proper time-weighted returns can only be calculated in the absence of interim cash flows. They are the norm in fixed income, but the calculation of time-weighted returns has never been an issue. Irrespective of the structure of the interim cash flows, any fixed income security is valued based on the embedded/equivalent zero-coupon (i.e. two bullet investment and distribution cash flows) structure, so that a compound average growth rate (CAGR) of return could be determined for the notional capital over the representative time horizon, conventionally expressed in annualized rate of return terms. For any of the fixed-income securities that, like private equity funds, are self-liquidating obligations, the proper way to consider the distributions of cash (coupons, pre-payments, etc.) during the life of the instrument is to consider the concept of duration.

Introduced in the late 1930’s by Macaulay and Hicks for the fixed income security analysis[i]^{, [ii]}, the concept of financial duration is not new in private equity. Duration was generically referenced and used for the purpose of IRR aggregation, as “an intuitive albeit imperfect correction” [iii]^{, [iv]} related to its high correlation with the IRR measure. The author should have instead properly noted the inverse causation of duration on the magnitude of IRR. Other authors have inferred duration from money-weighted metrics, as if it were a dependent variable[v]. Duration, rather than an imperfect correction (even for a money-weighted return!) is a precondition and independent variable for proper (time-weighted) performance measurement. 

With private market investments, the duration concept is even more critical than in fixed income. In fixed income, duration is only about the distributions’ stream, since the investment is paid in full at time zero. In private markets, the investment is typically constructed as a stream of cash flows, which creates a second duration reading to weigh in the performance calculation.

The Duration Adjusted Return on Capital (DARC) innovation

DARC is a patented and peer-reviewed methodology for the measurement of private markets performance in time-weighted terms[vi]^{, [vii]}. Its seminal three-step approach applies fixed income valuation techniques and leverages the concept of duration to fully explain private markets investment returns, including the impact of uncalled capital, of eventual credit and subscription lines, within a risk neutral, arbitrage-free framework.

DARC accurately considers the characteristics of the two obligations underlying both bonds and private equity funds. Firstly, the obligation of the investor to fund the investment and secondly, the obligation of the beneficiary of the invested funds to return them within a given time horizon, delivering an expected (but potentially aleatory) rate of return. 

In the case of bonds, the duration of the funding payment is time zero — a “spot” transaction. Instead, private markets investments typically have a “forward” nature, as the investment is not funded entirely upon subscription of the LPA. Consequently, the three modular steps of the methodology allow one to distill and reconcile all the aspects of private markets investment performance that are relevant for investors:

1. When the return starts to be earned, on average

2. For how long the return is earned

3. How much capital the return is earned on

The calculation of DARC: a risk neutral framework

For both contributions and distributions, DARC algorithms require the definition of a single bullet payment that is equivalent to the respective stream of cash flows. 

It is important to note that the conditions of non-arbitrage and risk neutrality should be respected. In fact, the first step of the DARC calculation implies that its algorithms are not meant to “price” a stream of cash flows but to establish the full equivalence between receiving/paying a stream of cash flows and a single bullet distribution/contribution when stipulating a risk-neutral condition. For this reason, cash flows (and NAVs, when considered liquidated at interim cut-offs) are transferred over time over the free-risk curve. An earlier or later cash flow event is equivalent, as their probability of occurrence stays the same over time, and the value of time is compensated for with risk-free interest payments.

The duration of private equity contributions and distributions is calculated as in the case of fixed income securities, i.e. the financial average of all the flows, in this case over the risk-free curve.

The forward attribute of DARC

In addition to the duration calculations, DARC algorithms generate two key outputs: the equivalent bullet contribution (EBC) and the equivalent bullet distribution (EBD), respectively the net present value contributions and distributions, each moved forward over the risk-free curve to the relevant duration placeholder.

The CAGR between the EBC and EBD over the net duration represents the DARC, i.e. the time-weighted return of the private equity fund being measured. Specifically, the DARC is a forward return because the net duration usually (i.e. if there is more than one contribution) occurs later than the commitment subscription or the first contribution – or the conventional date that is usually considered the time zero of the transaction. In other words, DARC puts a time- and amount-stamp on the return of a private fund, adding critical elements that traditional metrics completely neglect. 

It is worth reminding that IRR having, by default, given up its association with time and, therefore, being atemporal (and often incorrectly considered “spot”) does not capture private market investments’ typical deferred deployment of cash. All this implies that, in private equity, it takes all the years to full liquidation and a full commitment to get the IRR for a few years, forward only, on the called capital. The result is that the IRR is not telling a representative story about the performance of private funds. 

Instead, DARC time-weighted attributes allow all the possibilities that are the norm for all other asset classes. First, it takes advantage of the characteristics of the duration. DARC shows not only the duration/return of a fund but also the average duration/return of each investment of the underlying portfolio. Second, DARC can be properly averaged and compounded over time. But before doing that, DARC requires a transformation.

The spot equivalence of DARC and its attributes

Capital market standards compound spot returns. Therefore, DARC needs to be properly reframed over time to represent the return that contributions would earn from a time zero. Accordingly, the spot equivalent measure of the DARC can be measured by calculating the CAGR between the NPV of the contribution and the EBD over the duration of the distributions. 

But this is not the end of the required transformations, if private equity returns are meant to be used in a multi-horizon, multi-asset context. Different funds may have commitments drawn to a different degree over different time horizons. Proper asset comparability standards imply level playing field conditions of full-dilution and coherent time horizons. The methodology algorithms can deliver fully diluted equivalent measures of DARC over any time horizon.

Impact of DARC 

DARC corrects IRR, and the related money-weighted measures, in the context of time, correctly restating private equity performance measures as a function of time and amounts of capital invested. Just adding duration without proper calendarization and full dilution does not do the job for benchmarking nor for capital market usability in a multi-asset, multi-horizon framework. In particular, the importance of accurate calendarization is not about a “matter per se” but relates to the sphere of usability. The difference between knowing that a return is spot or forward is substantial.

On the one hand, DARC’s accurate additivity and compounding attributes maintain representativeness when the returns of different investments are aggregated or compared per equivalent unit of capital over identical multi-period time horizons. Worth mentioning in this regard is that these attributes eliminate the overshooting effect that characterizes currently used private equity return benchmarks – due to the heavy effect of the reinvestment assumption, which accompanies the use of since-inception or horizon IRR and Modified Dietz TWRR.

On the other hand, differently from IRR and other traditional performance measures (it goes without saying for ratios and relative return metrics), DARC yields are conceived for capital market usability. In other words, DARC yields are investable and fungible, as they can be characterized, without losing representativeness, as the tradable/matching swap rates of the physical underlying funds they measure. This paves the way for enhanced risk management and liquidity, and efficient total portfolio integration of private funds.

 

About the Contributor
 

Massimiliano Saccone is the Founder and CEO of XTAL Strategies and developed its patented DARC methodology. Beforehand, he was a Managing Director, ultimately Global Head of Multi-Alternatives Strategies, at AIG Investments, after stints at DWS, Deloitte, and KPMG. A CFA charterholder, qualified accountant, and auditor, he holds a Master's in International Finance from the University of Pavia, and a magna cum laude Master's in Business and Economics from La Sapienza University in Rome. He is an active volunteer at the CFA Institute, and a Lieutenant of the Reserve of the Guardia di Finanza.
 

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