Assessing Alpha in Private Equity Returns with Public Market Equivalent Analysis

17 Jul

Assessing Alpha in Private Equity Returns with Public Market Equivalent Analysis

With private equity experiencing a streak of record distributions over the past four years (figure 1), investors have been quick to re-invest to capture the value private equity brings. This is evidenced by the strong fundraising environment – PEI reported that 2017 H1 global private equity fundraising totaled $264bn, the highest H1 number since 2008 and the continuation of growth since 2010, according to analysis in Bain’s 2017 PE Report.

Figure 1. 2000 – 1H 2016 Global private market distributions, McKinsey Global Private Markets Review

Yet while there is unprecedented demand for private equity, investors need to be discerning when evaluating fund investment opportunities. According to Vanguard research using data from 1980 through 2012, only the top quartile of private equity returns have materially outperformed public markets. As private equity is primarily a return enhancer, rather than a risk diversifier, it is important to ensure you have a clear understanding of performance relative to other asset classes when evaluating future allocations to private equity strategies.

Figure 2. Private equity returns compared to Dow Jones US Total Equity Market Index, 1980 – 2012, Vanguard Group

Considerations when evaluating private equity outperformance

Investors are becoming increasingly sophisticated in their approach to evaluating private equity outperformance – in the eVestment 2017 Private Markets Due Diligence Survey, we found that 81% of respondents carried out public market equivalent (PME) analysis and 53% were expecting to increase their use of it.

However, the effectiveness of this comparison can depend heavily on the PME calculation methodology used and also the index it is benchmarked against.

Let’s explore how investors are utilizing PME analysis and the key areas to consider when selecting calculation methodologies and indices.

Public market equivalent methodologies in practice

Since the PME methodology was first proposed by Austin Long and Craig Nickels in 1996, “Long Nickels PME”, various calculation methodologies have been developed to counter some of this methodologies’ issues.

The current mainstream methodologies are Long Nickels PME, Modified IRR, PME Ratio (or Kaplan Schoar), PME+, and Direct Alpha. These vary from being directly comparable to Time Weighted Returns of public market indices, to being a ratio that indicates the level of outperformance acquired. Read the PME section of our investment statistics guide to learn more about each methodology.

While many methodologies exist, there is not one industry standard. In eVestment’s 2017 survey of investors and consultants, we found that 57% of respondents use more than one methodology, and 16% were using four methodologies.

As shown in figure 3, the most popular PME methodology used by respondents to the 2017 eVestment survey was Kaplan-Schoar, at 63% using it. Direct Alpha, the newest of the methodologies, was only used by 34% of respondents, and 19% used proprietary or other methodologies.

Figure 3. Investors and consultants use of public market equivalent analysis, 2017, eVestment

As an investor, what methodology should you choose? As there is no “right” answer, it highly depends on why you are using PME – is it to evaluate opportunity cost of your existing private equity portfolio? Is it to benchmark prospective managers? Is it to evaluate if your PE investments are worth the PE-level fees? Think about these questions and evaluate the nuances of each methodology in depth to decide which methodology/s are best for you.

For private equity fund managers, this data highlights that you need to be aware of how your track record’s performance looks across a variety of methodologies so you can cater to your investor base.

The importance of index selection

Selecting the right index to benchmark against is as important as choosing a methodology. To illustrate this, we’ll use the track record of a fictitious private equity manager, Silvermills Capital, carrying out the analysis in eVestment TopQ’s PME module.

In the above image, the S&P 500 and Russell 3000 have been included as indexes and we can see that they have returned around 5%. In comparison, Silvermills Capital generated an alpha equivalent to 13.3%, calculated using the Direct Alpha methodology.

On this basis, it appears that Silvermills Capital has vastly outperformed the index.

However, this GP is actually focused on growth equity tech investments. With S&P 500 companies being in a diverse range of industries, and having market capitalizations in the tens to hundreds of billions – is this still an accurate comparison? With this manager investing in different sectors at valuations much lower than those of S&P 500 and even Russell 3000, the return profiles and risk exposures are not necessarily comparable. To better gauge the opportunity cost of this PE fund investment, and the PE manager’s skill, an investor may want to instead use an index with a heavier weighting of tech stocks and a lower average market capitalization.

By comparing a growth manager to the NASDAQ instead of just the S&P 500 or the Russell 3000, we can see that the alpha is not as high as 13.3%, but it is still material at 11.8%. This shows the importance of using the correct indices when using your PME to find alpha.

From the results of our 2017 Due Diligence Survey, it was clear investors are applying this very tailored approach to benchmarking private equity to public markets –  73% use more than one index to do analysis and due diligence and 34%  vary the index based on the strategy they are pursuing (2017 Private Markets Due Diligence Survey). What this highlights for private equity managers is that it is crucial to understand the indices your clients are using, so you can appropriately benchmark useful. With eVestment TopQ, we provide over 200,000 public market indices to allow clients to tailor their benchmarking to suit their specific preferences.

In Summary

Evaluating private equity returns using public market equivalent analysis undoubtedly adds value and represents a powerful tool in the due diligence and performance measurement toolkit. However, as we have shown, the effectiveness of its ability to provide meaningful insight relies heavily on which methodologies and indices you use. What is also clear is that with the widespread adoption of the measurement by the investor community, private equity fund managers need to understand its application and how their portfolios look compared to PME metrics, not just IRR and TVPI.

Sophisticated analysis like this can be time-consuming and prone to error without sophisticated tools. eVestment’s private equity performance analytics tool, TopQ, includes a robust yet easy-to-use PME module that allows users to compare performance of managers to indices and methodologies of their choice. Learn more about how you can leverage this functionality here, or email us at if you’d like to speak to one of eVestment’s solution specialists about TopQ.