From Alpha to Market Beta in Private Market Funds

Investors in private asset funds, such as private equity and private infrastructure funds, aim to select top-performing fund managers. However, by definition, only 25% of funds can be in the top quartile, leaving most investors (Limited Partners, or LPs) with lower-performing funds. Measuring outperformance is crucial for LPs when selecting new managers or deciding whether to reinvest with existing ones. This paper explores different benchmarking methods to assess private asset fund performance using a large dataset of fund cash flow and NAV data.

1. Most fund returns come from market performance, not manager skill.

• Private equity fund managers function like active equity managers, with returns largely driven by market exposure (beta) rather than true outperformance (alpha).
• Private funds outperform public markets on average, but this does not help investors select the best managers.

2. Traditional benchmarking methods are flawed.

• Peer Group Comparisons fail to separate market-driven returns from manager skill, making manager selection unreliable.
• Public Market Equivalents (PME) use public indices, which do not reflect private market risks and returns, as benchmarks.

3. Private Market Equivalents (PtME) provide the best benchmarking approach.

• Uses private market indices to distinguish allocation alpha (sector selection) from pure alpha (manager skill).
• Findings show that most private funds generate zero net alpha after fees, confirming that manager skill is not consistently rewarded.
• Successful funds tend to outperform by choosing high-performing sectors rather than superior investment selection.

Investors cannot reliably pick top-performing managers using traditional benchmarks. PtME is the most effective method for assessing manager skill, revealing that true alpha is rare and primarily driven by sector allocation rather than investment selection.