Can Private Markets Have ‘Meaningful’ Benchmarks?

The Department of Labor’s proposed investment selection rule offers defined contribution plan fiduciaries a safe harbor if they evaluate investments, including private market assets, using six factors, including identifying appropriate benchmarks.

Simple, right?

In private markets, however, it can be anything but.

“Benchmarking is exceptionally difficult with private assets,” says Ken Wiles, executive director of the Hick, Muse, Tate & Furst Center for Private Equity Finance at the University of Texas. “It’s hard with public assets, but even worse with private assets.”

That difficulty could become particularly important for plan sponsors under the DOL’s proposed regulation governing the selection of investments for defined contribution plans. The proposal establishes a process-based standard for fiduciary prudence under the Employee Retirement Income Security Act by requiring fiduciaries to evaluate six factors—performance, fees, liquidity, valuation, complexity and benchmarking—when considering investments for the plan.

Under the proposal, a fiduciary must determine that each investment has a “meaningful benchmark” and compare its risk-adjusted expected returns, net of fees, against it. The DOL defines that benchmark as an investment, strategy, index or other comparator with similar “mandates, strategies, objectives, and risks.”

Though the proposed rule was created to establish a regulatory framework to spearhead wider use of private investments in DC plans, benchmarking has become important in ERISA litigation, where courts have wrestled with whether plaintiffs alleging imprudence have identified sufficiently comparable investments. Private assets, known for their illiquidity, limited data and wide performance dispersion, can make apples-to-apples comparisons difficult.

A Benchmark That Doesn’t Quite Exist

With publicly traded investments, fiduciaries can generally observe market prices and compare performance against widely accepted indexes. The same is not true for private investments.

Even familiar private market measures have drawbacks. Internal rate of return, for example, can rely heavily on estimated asset values before investments are sold. Public market equivalents attempt to compare private portfolios with public investments, but finding genuinely comparable public companies can itself be difficult.

“There is no standard benchmark,” Wiles says. “There’s no standard, industry-accepted way to specifically measure the performance on a risk-adjusted basis.”

Gregory Brown, a professor of finance at the University of North Carolina’s Kenan-Flagler Business School, sees another complication: Private-market indexes, themselves, can have different return and risk characteristics.

Some indexes are built using proprietary information and cannot be independently replicated. Others can suffer substantial reporting lags. Unlike an S&P 500 Index mutual fund or a collective investment trust, investors cannot necessarily invest in or replicate a private market benchmark.

The ideal, Brown says, would be a private market benchmark based on the prices investments would receive in a functioning secondary market.

“But that data just doesn’t exist,” he says.

That does not mean useful private-market benchmarks cannot be built. Newer efforts are attempting to provide greater granularity. HarbourVest, for example, recently published private equity benchmarks built from 66,000 underlying private equity and venture capital transactions, including sector-level performance. 

But even sophisticated benchmarks illustrate the difference between private and public markets. HarbourVest notes that its benchmarks incorporate estimated valuations based partly on subjective assumptions, and some returns are presented gross of management fees and carried interest.

“Benchmarks need to be constructed from the underlying investment-level data, the same way that [the] S&P 500 or MSCI All Country World is constructed from the underlying public company performance data,” says Sofia Gertsberg, HarbourVest’s head of quantitative investment science.

The DOL’s Solution

The Department of Labor acknowledges the problem.

One example in the proposed rule considered an asset allocation fund containing a private equity sleeve alongside publicly traded stocks and bonds. In the example, an independent investment advice fiduciary constructs a composite benchmark, using broad securities indexes for the public portions and a combination of internal rate of return and public-market-equivalent methodologies for private equity.

Crucially for plan sponsors, the DOL stated that the named fiduciary does not need to become an expert in benchmark construction. It can prudently hire an independent investment advice fiduciary, provided the sponsor reads, critically reviews and understands the explanation of the benchmark.

But Fred Reish, counsel for Ferenczy Benefits Law Center, says that could still represent a substantial change in practice. If, for example, a target-date fund allocates 10% to private equity, Reish says the benchmark may need to reflect that allocation. And because allocations change along a target-date glide path, different vintages could require differently constructed comparisons.

“Multi-asset-class funds like target-date funds are obviously the most difficult,” Reish says. “Because every five years, [the benchmark composition] changes.”

Reish expects that fund managers or data providers will likely do much of the actual benchmark construction. Advisers, however, would still need a basis for determining that the resulting comparator appropriately represents the investment, leaving the fiduciary with an obligation to understand the recommendation.

For many sponsors, particularly outside the mega-plan market, that is not how investment monitoring works today, he says.

Litigation Protection—or a New Litigation Question?

That distinction matters, because litigation risk is part of the reason the DOL is proposing the safe harbor in the first place. The department has made clear its focus on reducing litigation risk for plan sponsors, and the benchmarking definition draws explicitly from federal appellate decisions requiring plaintiffs to make meaningful investment comparisons.

The issue is also before the Supreme Court in its October term in Anderson v. Intel Corp. Investment Policy Committee, a case involving Intel retirement plans that invested in hedge funds and private equity. The litigation raises the question of what the plaintiffs must allege to establish an appropriate comparator when claiming an investment underperformed.

For plan sponsors, however, a safe harbor built partly around meaningful benchmarking could also shift attention from whether the fiduciary benchmarked an investment to how they chose the benchmark in the first place.

Jerry Schlichter, managing partner in Schlichter Bogard, whose firm represents plaintiffs in ERISA litigation, called private equity benchmarking “fraught with peril” for plan fiduciaries. Among his concerns are limited information about underlying portfolio companies and the difficulty of benchmarking illiquid holdings, or illiquid portfolios. He says sponsors may need to demand more information from private equity managers than those firms have traditionally provided.

New Level of Scrutiny

Yet another challenge in benchmarking private market investments is that even after the investment has run its course, determining whether it met return expectations on a risk-adjusted basis may remain debatable.

“Five years from now, we can disagree,” says Chris Flynn, head of research at CEM Benchmarking, “even after the events happen, about whether private equity beat public equity on a risk-adjusted basis.”

That may be the central challenge for plan sponsors considering private markets under the DOL’s proposed framework. The proposed rule offers fiduciaries a process for making decisions about all investments, including categories of investments that ERISA has never categorically prohibited. But satisfying that process could require a level of benchmark construction and scrutiny that many DC committees have never undertaken.

Reish expects the industry to adapt. But doing so, he says, will require managers, fund providers, data companies, advisers and sponsors to get accustomed to “a new, more complicated, more time consuming and maybe even more expensive way” of evaluating investments.