Paper From Japan’s GPIF Proposes New Way to Compare Alts With Traditional Assets

A working paper published by Japan’s Government Pension Investment Fund details a new method that claims to more accurately compare the performance of private equity funds and traditional assets.

The authors of the paper intend the method to be applicable not only to private equity funds, but also to other alternative assets such as infrastructure and real estate.

Currently, investors use what is known as the public market equivalent to measure a private equity fund’s performance relative to the listed market. PME metrics benchmark the performance of a fund, or a group of funds, against a public market index. According to the paper, the so-called “direct alpha method” for PME is often considered by many to be the best available method among the various PME methods.

“On the other hand, it is not always clear whether the direct alpha method is appropriate from the perspective of finance theory,” the paper argued.

The issue with the direct alpha method, according to the authors, is whether it is appropriate to obtain the internal rate of return, which is used to measure alternative assets, “by converting the cash flows generated at each year to present value at the benchmark return and then considering these as having occurred at the year in question.”

The authors propose what they call the Spread Based Direct Alpha and a method for deriving the alpha amount based on SBDA. They said the inspiration for the SBDA comes from the concept of credit spreads in the bond market, specifically the credit spread over the spot rate of bonds with the relevant maturity.

According to the paper, the SBDA method can compare the performance of a private equity fund “fairly accurately” with those of traditional assets by splitting the performance of private equity funds into the beta part and the alpha part, i.e. the performance of the benchmark on one side and the pure performance of private equity funds on the other.

The SBDA and the alpha amount based on the SBDA, according to the paper, were created to measure the performance of private equity funds in order to satisfy two requirements: that the alpha portion, which “expresses the pure skill” of the private equity fund, should be extractable, and that the performance relative to the GPIF’s policy benchmark for foreign equities should be measurable.

“Whether or not the double mandate is actually met in practice will need to be examined from various perspectives in the future,” the paper stated. “In the process, it will also be essential to improve the SBDA and the corresponding alpha amounts.”