For those of you who know me, you know that returns, performance and benchmarking issues are near and dear to me – after all, my first child’s initials are IRR. I swear it was not intentional – just call it karma.
I recently took our second child, (no weird acronyms here to make fun of, fortunately) for his six month checkup. He was weighed and measured and I saw a notation that the nurse made on his chart – weight and height – 25% percentile. As a proud daddy, with too many years of experience reading private equity presentations I guess, I immediately thought – “wow top 25% percent” – that’s pretty good, until it dawned upon me that they were using the mathematical percentile – which meant the bottom 25% percent – he’s still a little peanut – no Texas Tech linebacker in this family I guess.
I bring this up because I thought to start this forum I’d begin with one of the phrases that will cause just about any LPs eyes to roll–“We are a top quartile fund”. I was recently on a panel discussion at a large major private equity conference that was trying to ascertain how to define top performing managers. One of the questions asked “how many top quartile managers are there” – for a laugh, I very quickly quipped – “25% of the existing managers”. I guess the other answer is “All of them”, because you don’t really ever see any group without that claim. It has become so ubiquitous that I don’t think anyone pays attention anymore.
But in all fairness and in defense of the industry, I don’t think I’ve ever opened up an investment magazine and seen any public mutual fund or investment manager claim that it’s ranked number two in its peer group. Everyone is number one. Which means that it is up to the investor to determine what is meant by “top quartile.”
What it is supposed to mean is the following: Take your fund’s net IRR (net of fees and carried interest) since inception of the fund and compare it the benchmark (take your pick of providers, I’m now agnostic) of the same vintage year group (more on sorting out that conundrum in another post). If you a 2001 vintage year venture capital fund, then compare it to the benchmark of all 2001 vintage year venture capital funds. If you a buyouts fund, use the buyouts benchmark. – if the IRR is are at or above the 75% percentile IRR of all funds in that vintage year, then you are a top quartile fund.
Of course questions abound – What defines a vintage year? Whose benchmark to use? – Can you be a top quartile fund on the basis of investment multiple instead of IRR? What if we are a special-situations hybrid later stage growth-oriented buyout group with a focus on Midwest biopharma platforms? What do I use? More on these questions later.