AlphaWeek Q&A: Jeffrey Knupp, President, DSC Quantitative Group
AlphaWeek's Greg Winterton discussed the developments of index products for the private equity asset class with Jeffrey Knupp, President of DSC Quantitative Group. DSC has partnered with Thomson Reuters to produce the Thomson Reuters Private Equity Buyout and Venture Capital Indices, which provide daily valuation insights into these asset classes.
GW: Jeffrey, thanks for taking the time. Is there a difference in the behaviour between public and private market equities, and if so, how do you replicate private market using public securities?
JK: Private equity-backed companies and publicly listed equities share specific characteristics that are common to all equity securities and respond to economic headwinds and tailwinds in similar ways. While there are some pronounced differences between the two asset classes, replication of private equities by public equities is still viable.
To replicate the PE asset class, we employ a top down approach that is driven by detailed information on thousands of private equity-backed companies from our partner, Thomson Reuters. By aggregating the individual company details, the idiosyncratic elements of individual companies tend to neutralise each other out, leaving the systematic return drivers of the asset class. As a result, we are able to construct a tracking portfolio in the same way one might replicate the S&P 500 with just a subset of the index’s constituents or by using equities not included in the index.
GW: Is finding the right manager more challenging in the PE space than a traditional global equity manager?
JK: Private Equity managers take on much more active management risk than their peers in the global equity space, largely driven by the fact that they run much more concentrated portfolios (typically 10-12 names) and because there is no natural benchmark for them to manage towards. This can be both a positive and a negative factor, but it clearly makes identifying top managers significantly more important to success in the private equity class than with traditional global equity managers. Compounding this issue for pensions and other traditional PE investors is the reality that identifying top managers has become increasingly difficult due to the decrease in performance persistence among PE managers, according to a forthcoming study by MIT professor Antoinette Schoar.
GW: What is the likely role for index products in the PE industry?
JK: Our conversations focus on large, institutional investors with well-established PE programs. For these groups, index products are viewed as a complement to their existing private markets sleeves. Some investors look at index products in the context of a core-satellite framework. Others look at them as a tool for asset class exposure management or a way to reduce overall asset class fees. For investors that may be subscale and utilise Funds of Funds, index products may represent a compelling alternative that can provide diversification benefits, but likely with lower fees and greater liquidity.
GW: Liquidity, fees, exposure management, and access are big investor challenges in the PE and VC world. What are the latest views on these points and what are the solutions?
JK: Fees are clearly top of mind for most investors these days, even as many try to balance developing long term relationships with an appropriate alignment of fees. There also appears to be widespread recognition of the challenges in simply comparing performance among managers utilising IRR metrics exclusively. Even when using additional performance metrics like Multiples on Invested Capital (MOIC) or PME frameworks, challenges often remain due to frequent use of subscription lines and an overall lack of a standard calculation methodology or a framework that would allow for easier comparisons to other asset classes where time weighted returns are the norm.
GW: What is the most effective way to replicate the performance of PE?
JK: While there may be a number of different ways to approach replicating the PE asset class, we feel strongly that an essential characteristic is a direct tie to the asset class. For our firm, this means having a Research Index comprised of thousands of underlying private equity-backed companies and a related investable index that seeks to track the Research Index. Without such a construct, it is difficult to state that an index is truly delivering the risk and return characteristics of the Private Equity asset class.
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