An important theme that we’ve heard in talking to investors recently has been the challenge of making commitments over the next two years. On the one hand, some investors feel that 2010 and 2011 are likely to be years with good opportunities to invest – prices are down from their pre-crash highs, and many good managers are bringing funds to market. On the other hand, some investors fear prices have already rebounded and that there is plenty of dry powder sitting idle on the sidelines, eagerly looking for transactions to invest in before commitment periods expire.
Either way, private equity investors are more allocation-constrained and cautious than in any time in recent memory. Many investors already have large uncalled commitments to private equity, and some have limited liquidity due to the overall market decline. As a result, investors are feeling the need to make sure that they have the solid information they need to maximize the value of an extraordinarily valuable resource: 2010-2011 commitments to private equity.
At the same time, changing perceptions are making investors rethink their allocation budget and their commitment process. Despite the widespread belief among consultants and investors that private equity as a class has low correlation to the public market and high returns, recent news and research suggest that this is probably not the case.
Ultimately, it appears that private equity is just some kind of levered equity, and that successful private equity investing is not at all automatic. Where private equity differs from the public market is that it is illiquid and inefficiently priced. For those reasons, it’s possible for some private equity limited partners to harvest or capture the elusive alpha – the non-market return due to manager skill or information. But alpha is not easy to find and it’s even harder to harvest.
We have put together a white paper that discusses some of the evidence that a sub-set of investors are able to harvest positive alpha, even though private equity in aggregate appears to have none. We will also discuss some of the limitations of popular approaches to fund selection, and why so many investors make suboptimal decisions. Rather than leave our audience with more questions than answers, we discuss a new algorithm for estimating alpha in private equity that takes advantage of the kinds of information that private equity investors typically possess, without requiring information that they cannot know. Finally, we will demonstrate how this algorithm can be used to measure a limited partner’s ability to find and harvest alpha as well as a general partner’s capacity to create alpha for its investors.
Using this new tool for estimating alpha, private equity investors can improve their fund commitment process. Some investors might even come to the conclusion that their current process hasn’t actually captured any alpha, which would likely lead to an entirely different conversation.