Understanding Private Market Performance: A Beginner's Guide to Real Returns
Navigating the world of private markets—where investments are often illiquid and not traded openly like public stocks—can be daunting.
Currently, the private market landscape is particularly challenging. High borrowing costs are impacting returns, and exit strategies for investments are proving difficult. Meanwhile, regulators are stepping in, and an age-old question is back in the spotlight: How do we truly measure the performance of these opaque investments?
The Complexity of Measuring Private Market Success
Private markets include buyout funds, venture capital, and other forms of private equity. Unlike public stocks, where prices are visible daily, private investments don't have the same transparency, making performance measurement tricky. Many fund managers even "grade their own homework," deciding the value of their holdings and reporting the results themselves. While these returns may look good on paper, it’s tough to tell if they’re actually delivering value beyond what might be achievable in more liquid, less costly investments.
Barry Griffiths, a former head quantitative analyst, believes there’s a way to better understand these investments. Griffiths and a small group of quantitative analysts have developed “direct alpha,” an approach that allows investors to compare private market returns with public market benchmarks. This lets investors see if their private investments are generating returns above a chosen public market, such as the S&P 500. Although still new, this method aims to provide a clearer picture of performance, helping investors make more informed decisions.
Understanding “Direct Alpha”
Alpha is a financial measure that tells us how much return a fund manager has generated above a standard market index, like the S&P 500. In public markets, alpha has been a common metric, but it’s a new concept in private markets. Direct alpha compares the cash flows (money invested and returned) of private investments against a public benchmark, showing if private funds earned more than a similar public investment would have.
Direct alpha’s uniqueness is its ability to present this result as an annual percentage—something investors are familiar with when evaluating performance. A study led by Griffiths, along with co-researchers, applied direct alpha to over 2,400 buyout funds. They found that while average returns looked decent, many funds provided just a small return over the public market, and some fell short altogether. This showed that even seemingly strong absolute returns often depended more on broader market conditions or specific industries rather than skillful management.
Private Markets Face Growing Pressure for Transparency
Direct alpha is attracting the attention of major investors, like Japan’s Government Pension Investment Fund and Norway’s sovereign wealth fund, both of which are using it to gain a clearer view of private market investments. While this method may be slow to catch on industry-wide, its potential to highlight whether private funds deliver real value—or simply benefit from favorable timing—has big implications.
For example, Mark Anson, CIO of the Commonfund, has found that traditional private market reporting doesn’t capture the true volatility of private investments. By using direct alpha and other “unsmoothing” techniques, he’s able to assess risks more accurately and adjust allocations to better serve long-term goals.
The Future of Private Market Analysis
The private market industry is slowly changing. Large investment managers like BlackRock are investing in tools to increase transparency, helping investors better assess private investments. But as Griffiths points out, it will likely be a long process. Direct alpha and other new methods are making headway, and as private markets evolve, tools like these will help investors navigate the complexities of private assets and make more confident, informed investment decisions.
For newcomers, understanding private markets may seem challenging, but tools like direct alpha offer a new level of insight. By comparing private investments to public benchmarks, direct alpha allows investors to see beyond simple returns and assess the true added value of these assets.
*Disclaimer: Not Financial Advice. Investors should conduct thorough research and seek professional advice before making any investment decisions.
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