Benchmarking the Unbenchmarked: Performance in Illiquid Alternative Investments

Measuring the success of illiquid alternative investments, such as private equity, real estate, infrastructure, or hedge funds with lock-up periods, presents a unique challenge compared to publicly traded assets. The very nature of their illiquidity – the inability to easily buy or sell them on an open market – necessitates specialized approaches to performance measurement and benchmarking. Unlike stocks or bonds with daily price quotes, the value of illiquid alternatives is often determined periodically through appraisals or internal models, leading to less frequent and potentially smoothed performance data.

One of the primary metrics used to evaluate illiquid alternatives is the Internal Rate of Return (IRR). Think of IRR as the discount rate at which the net present value of all cash flows (capital contributions and distributions) equals zero. It essentially represents the annualized effective compounded rate of return. While IRR is widely used and understood, it can be sensitive to the timing of cash flows, especially in the early years of an investment. A front-loaded investment with quick distributions might show a high IRR initially, which could moderate over time.

Beyond IRR, several other metrics are crucial for a comprehensive performance picture. Total Value to Paid-In Capital (TVPI), also known as the multiple of invested capital, is a simple ratio dividing the current value of remaining holdings plus cumulative distributions by the total capital invested. TVPI shows the overall return multiple, indicating how many times the initial investment has been multiplied. Distribution to Paid-In Capital (DPI), or cash-on-cash return, focuses solely on realized returns, dividing cumulative distributions received by the total capital invested. DPI is particularly important for investors seeking actual cash returns rather than paper gains. Finally, Residual Value to Paid-In Capital (RVPI) measures the unrealized return, dividing the current value of remaining holdings by the total capital invested. RVPI complements DPI to provide a complete view of both realized and unrealized value creation.

Benchmarking illiquid alternative investments is equally complex. Simply comparing them to broad market indices like the S&P 500 is often misleading due to differing risk profiles and asset class characteristics. Instead, benchmarking typically relies on peer group comparisons, public market equivalents (PMEs), or custom benchmarks.

Peer group benchmarking involves comparing the performance of a fund or investment against similar funds or investments within the same asset class, strategy, and vintage year (the year the fund started investing). Services like Preqin or Cambridge Associates aggregate performance data from numerous private funds, allowing for quartile rankings and percentile analysis. However, finding truly comparable peers can be challenging. Funds may have different mandates, geographic focuses, or risk tolerances, even within the same broad category. Furthermore, peer group data is often lagged and may suffer from survivorship bias (underperforming funds are less likely to report data over time).

Public Market Equivalent (PME) methods attempt to bridge the gap between liquid and illiquid markets by comparing the cash flows of a private investment to a hypothetical investment in a public market index. Several PME methodologies exist, such as the Kaplan-Schoar PME or the Long-Nickels PME, each with its own nuances in how they discount and compare cash flows. PMEs provide a useful perspective on how an illiquid investment performed relative to a readily investable public market alternative, but they are still imperfect. Choosing the appropriate public market index is critical and can significantly impact the results. Additionally, PMEs don’t fully capture the specific risk-return characteristics of illiquid investments or the value added by active management in these spaces.

Custom benchmarks offer a more tailored approach. These benchmarks are constructed specifically to reflect the investment strategy, risk profile, and market environment relevant to the illiquid investment being evaluated. For example, a custom benchmark for a European infrastructure fund might include a blend of European infrastructure indices, adjusted for leverage and sector exposures. While custom benchmarks can be more relevant, they require significant expertise to construct and maintain and can be less transparent than peer group or PME benchmarks.

Ultimately, measuring and benchmarking illiquid alternative investments is not an exact science. It requires a nuanced understanding of the limitations of each metric and benchmarking approach. Investors should consider a combination of metrics and benchmarks, focusing on long-term performance trends rather than short-term fluctuations, and always critically evaluate the comparability and relevance of any benchmark used. Transparency from fund managers regarding valuation methodologies and benchmark selection is also paramount for informed performance assessment.