Abstract
Evaluating and quantifying the strengths and weaknesses of the investment process is key to portfolio managers, senior management, consultants and investors; performance attribution addresses this challenging task. However, the nature of private equity makes it difficult to apply any of the well-established public equity performance attribution models. Therefore, we have developed an innovative model for private equity, which dissects the private equity portfolio performance into a base factor and four premiums: Illiquidity Premium, Strategic Asset Allocation Premium, Tactical Asset Allocation Premium and Manager Alpha. The Tactical Asset Allocation Premium can be further broken down into the Commitment Timing Premium and the Strategy Timing Premium. The base factor is called Passive Public Equity Performance and each premium relates to a distinct step in the investment process, allowing for quantification of strengths and weaknesses throughout the investment process.
In this paper, the model is illustrated using the private equity portfolio of two North American pension funds whose data is publicly available. Firstly, both data sets had to be cleaned up - funds with incomplete cash flows and funds that lack an appropriate benchmark were removed – and then the model was applied to a 10-year time period ranging from 2003 to 2012, which offered good quality data.
As a result, both pension funds were able to collect a positive Illiquidity Premium of above 4% over the Passive Public Equity Performance. The Strategic Asset Allocation Premium was positive for both pension funds as well. The higher strategic allocation to US buyout funds, coupled with the strong US buyout market performance, led to a higher Strategic Asset Allocation Premium for the first pension fund. However, due to very large commitments to the underperforming vintage year 2006, the Tactical Asset Allocation Premium of the first pension fund was negative. The second pension fund exhibited the largest exposure to the 2008 vintage year, which performed better than the pre-crisis vintage year 2006. This led to a higher Tactical Asset Allocation Premium. The second pension fund was able to strike a positive Manager Alpha, while the first pension fund was not able to achieve such. This is not surprising, as the size of these investors forces them to hold highly diversified portfolios and/or focus on the large cap market, thereby reducing the probability of achieving a positive Manager Alpha.