Could This New Metric Upend Private Equity Compensation?

Landmark and New Mexico PERA have come up with a way to calculate the true value a private equity firm creates — a measure they believe could fundamentally change fee structures.

Illustration by II

Illustration by II

A secondaries investor and public pension fund are publishing what they say is the first methodology for calculating the dollar value of excess returns generated by private market investments.

The new measure, called excess value, was developed by Landmark Partners and the Public Employees Retirement Association of New Mexico. It is intended to help investors distinguish between returns generated by the market — so-called beta — and the dollar value of profits created by a private markets manager. But in addition to helping investors better understand and analyze the performance of private funds, the method may shake up fees and compensation.

According to the paper, which is forthcoming, one of the reasons behind developing the metric was to “enable investors and fund managers to develop compensation agreements that, unlike traditional carried interest, distinguish between profits attributable to market returns and profits that represent returns above or below market.”

Avi Turetsky, a managing director in Landmark’s quantitative research group and one of five authors of the paper, said the genesis of the research was from a conversation that Landmark had with New Mexico PERA about a year ago. “The question was, ‘Could we measure the alpha that a private manager produces in dollars?’” Turetsky said in an interview with Institutional Investor.

Prior academic research has measured alpha in multiple and rate terms, but not in dollars. Turetsky said that calculating outperformance in dollars is necessary if the measure is to be used for compensation purposes.

The researchers wanted to put private markets on an equal footing with both hedge funds and traditional managers, which are judged by the returns that they create beyond what could be achieved with a cheaper index strategy or a fund that provides exposure to systematic factors like value or growth.

“A private market investment may generate value because of its exposure to broad macroeconomic conditions, or to certain sectors or geographies,” the authors wrote. “Since LPs can generally achieve these exposures more cheaply via public markets (e.g., through low-cost ETFs), they may not want to compensate private market managers for this portion of performance.”

The carried interest model currently used by most private market managers “is at odds with this objective,” the authors continued. “By basing compensation on absolute return thresholds, the traditional model can lead LPs to pay high fees for mere market returns.”

At PERA, the investment office evaluates its entire portfolio in terms of excess returns, according to Joaquin Lujan, director of rates and credit and one of the study’s authors. He said private equity shouldn’t be any different.

“It’s just a principle of ours,” he said. “We do it whether it’s a large-cap growth, fixed income, or hedge fund manager. We said in PE, we want to identify the [profit] split and sit across the table from a GP and tell them what we think their excess value is worth.”

Ultimately, the pension plans to use the excess value method with all of its private markets managers. So far, it’s using the measure to determine compensation for a contingent credit strategy.

“People aren’t investing in private equity to replicate what they could get in public markets,” Turetsky said. “Excess value gets you there. Now you can measure the dollars that a private equity fund generates over a public market alternative and you can say I want to compensate you only for the value above that.”