Manager selection is still not easy, however. One of the oft-quoted attributes in assessing PE as an asset class is the concept of positive performance persistence. Unlike most other asset classes, the phenomenon of performance persistence in PE managers is a documented reality. Persistence has obvious implications for portfolio construction, as long as investment discipline and management are constant. However, while performance persistence is useful, investors need to be careful not to make inappropriate investment decisions based on its expectation, as it is relatively imperfect.
The issue is further muddied by recent studies of performance claims made by PE managers over a 20-year period, which showed that two-thirds claimed “top quartile” performance. While this would normally (and rightly) raise eyebrows, it is as much a symptom of the state of imperfection in performance benchmarking in the PE industry where managers can select the benchmark of their choice, depending on dataset and vintage year (when the fund was created).
However, this means that investors should be wary of the lure of “top quartile” performers, as obviously being in a top quartile somewhere is not necessarily a meaningful criterion for assessing the quality of a manager. Such benchmarks are necessarily constructed using funds that tend to be highly heterogeneous due to size difference, strategies employed, management styles and vintage years. Without some significant refinement in the future, it is dif- ficult to make meaningful ongoing comparisions.
When dealing with direct PE funds, asset allocation also needs to take into account several issues. While having diversification attributes, the ability to accurately judge the true correlation between PE and public equities is far from straightforward. It obviously has some positive correlation attributes, because public and private markets remain equity linked, but the correlation is not direct and the effect of valuation lag in assets can have a significant effect. Like investments in direct property, the impact of valuation lags has the potential to artificially mask “true” standard deviation of returns, which has implications for asset allocation strategies.
At the very least, PE is not strongly correlated to public equity, but it would rarely have a negative correlation over the longer term.
However, the net effect to investors remains the same: this is an asset class where an allocation should only be made if investors believe they have the ability to identify (and gain access to) managers likely to be the top performers. Due diligence on manager track record is paramount and often extremely difficult in the retail space given the requirement for understanding how returns have been generated and what is being measured.
Private equity remains an asset class which can be an excellent contributor to performance when done correctly and can offer above-average returns. However, it is not an asset class that will be suitable for all retail investors and should be approached with a high degree of caution. Sufficient due diligence to unearth top managers is vital to take advantage of the high absolute returns that the asset class is capable of generating.
Dug Higgins is a senior investment analyst at Zenith Investment Partners – www.zenithpartners.com.au
