This article is from the August 1, 2001, issue of Red Herring magazine.

It's time for the private equity market to grow up, says Susan Woodward, former chief economist at the Securities and Exchange Commission, and disclosure zealot. And whether the private market's Peter Pan-complexed venture capitalists and institutional investors agree or not, Ms. Woodward plans to drag private equity into something resembling maturity.

The thing about the private market is, it's private, a world where specific information regarding risk and return is reserved for investors. Until now, it's been difficult for private investors to compare the performance of their portfolios to a good benchmark, says Ms. Woodward. Because investment in private equity increased from millions of dollars in the late '80s to single-digit billions in the '90s, there is a growing need for tools to quantify its performance. "Private equity is here to stay," she says. "But it's time for professionals to have quantitative measures to monitor their advisers and to monitor their portfolios."

From her Menlo Park, California, home office, Ms. Woodward and fellow economist Zach McReynolds are cooking up the Sand Hill Index, a private equity index that serves to benchmark the universe of private investment. The problems in creating such an index are not small from an economics perspective. Private firms don't have to report to anybody. Sometimes they share valuation information, but most of the time (about 70 percent, according to Ms. Woodward) they won't. Deals are priced intermittently -- when companies are raising funds -- not continuously. Among economists these problems are described as selection bias/data censoring and intermittent pricing.

LOOK OF REVELATION With the help of research by last year's Nobel Prize winners for economics, James Heckman and Daniel McFadden, and her own considerable economics chops, Ms. Woodward says she has surmounted both those problems. For the wonks, Ms. Woodward's proprietary, patent-pending econometric process involves regression of logarithms based on demivariables to create a set of coefficients that result in an index of value. Data-censoring adjustments are then thrown into the batter; the less data you get to see, the more you discount what you do see.

The Sand Hill Index for 2000 is not yet complete, but Ms. Woodward thinks the picture it will show will be far grimmer than those offered by data firms like VentureOne and Venture Economics. She estimates her index will show a decrease in annual returns of about 60 percent, compared to the slip in returns of 11 percent that the data firms are touting.

Ms. Woodward is not claiming perfect knowledge with the Sand Hill Index, which she plans to sell quarterly and eventually monthly to institutional subscribers. Rather, she is offering much better visibility into something that has been largely invisible. "Will the index that we build be as strong an indication of value as, say, the S&P 500? No," she says. "But it will be lots better than anything that is out there now, [which] is maybe half a dozen published studies, all of which suffer from acute selection bias because they are somebody's set of very good news that they were willing to share."

Ms. Woodward is guessing that not everyone will embrace the truth as revealed by the Sand Hill Index. "On the one hand, the VCs and other professionals will sort of hate it, because it imposes a standard on them that they didn't have to be subjected to before," Ms. Woodward says. On the other hand, she says, better information could increase public interest in private equity.

Early in her career, Ms. Woodward saw the financial industry fight another econometric tool, the asset-pricing model. Among its applications was measuring portfolio performance against the public market as a whole. "They resisted, because if you don't beat the market, or at least come close," she says, "then you're sent back to the used-car lot."

Write to michael.copeland@redherring.com.