I was at a private equity conference last week focused on issues of interest to Limited Partners. One of the things that struck me was several Limited Partners who described investing in private equity as “the search for alpha.” While in the past I have heard many Limited Partners talk about alpha, I have found very few who actually attempt to measure alpha. Without measuring alpha, how can one even pretend to be searching for it?
What is alpha?
Since it has probably been years since many of the readers of this blog have thought about finance theory, it’s worth exploring the definition of alpha. The textbook definition of alpha is “the abnormal rate of return on a security in excess of what would be predicted by an equilibrium model like the CAPM or APT” (Investments, Bodie, Kane & Marcus).
In practice, it is used as a measure of manager skill. While alpha can be calculated using a variety of models, the Capital Asset Pricing Model (CAPM) is most frequently used. The CAPM states that the return on any asset equals:
Ra = α + Β (Rm – Rf)
Ra = return on the asset
B = the correlation of the asset to the market portfolio (beta)
Rm – Rf = the expected return on the market portfolio above the risk-free rate (the equity risk premium)
In an efficient market, α is equal to the risk-free rate such that the return of a zero beta portfolio should be the risk-free rate.
The challenge with calculating alpha in private equity
Many hedge funds, especially those employing long-short equity strategies, currently report alpha in their monthly and quarterly reports. When assets are actively traded, funds can easily calculate the correlation of returns to market (beta). Using the CAPM or a similar model, the fund can then provide an alpha calculation given an assumed risk-free rate and equity-risk premium. The challenge in private equity is that the fund’s assets are not marked-to-market, complicating any calculations to correlate the market with the fund’s performance. As such, I am unaware of any private equity fund that reports either alpha or beta.
Despite the challenge in measuring alpha in private equity, institutional investors should not give up. To measure the beta of a portfolio of illiquid assets (and then the alpha), the institution could create a basket of similar publicly traded securities. For example, to calculate the beta for a private equity fund that invests primarily in the transportation industry, the investor might begin with the beta of the Dow Jones Transportation Index. If the fund employed 3x leverage, the beta should then be approximately tripled. If a fund invested primarily in early stage venture capital, the investor might start with the NASDAQ index. While the method described can be challenged on many levels, all performance measurement requires some degree of estimation. Further, there are other methods that the investor could and should consider.
Why alpha matters now
I believe the changes in the private equity market have made it increasingly important for the institutional investor to think about the alpha in their private equity portfolio. Here are four reasons to consider:
- Leverage has never been higher. Leverage increases return, but also increases risk. Alpha measures return independent of leverage, which is exactly what investors should be seeking.
- In a rising tide, skill is hard to distinguish from market exposure. If we look back at the late ’90s Internet-driven VC returns, many investors really only had market exposure. Given the extraordinary returns that have recently been posted in buyout funds, it is prudent to try to separate skill from market exposure.
- Larger portfolios may have a higher beta. As private equity pools increase in size they are likely to be increasingly correlated to the market. Those managers that are able to achieve superior returns should be rewarded appropriately.
- Highly correlated private equity portfolios are high-fee vehicles. If an investor is only buying market exposure, the typical private equity fees of 2–20% are extremely high. Investors should be mindful of getting value for their dollar.
In summary, rather than trying to find alpha, perhaps the investor should start by trying to measure alpha. The techniques aren’t perfect, but they should be the start for the true search for alpha.