Assessing Alpha in Private Equity Returns with Public Market Equivalent Analysis

17 Jul

Assessing Alpha in Private Equity Returns with Public Market Equivalent Analysis

Private equity’s rise in popularity among institutional investors has been due to its return enhancing capabilities compared to other asset classes – evidenced by the record distributions to investors in recent years. Yet not all PE managers will provide this level of returns. Investors are becoming increasingly sophisticated in evaluating the alpha of both their current investments and track records of prospective managers. Let’s look at how you can leverage Public Market Equivalent analysis to identify alpha, and the key questions to ask when selecting a calculation methodology and index.

An Introduction to Public Market Equivalent Analysis (PME)

PME is a measurement within the industry that is rapidly growing in use. In the eVestment 2017 Private Markets Due Diligence Survey, 81% of respondents carried out PME analysis and 53% were expecting to increase their use of it.

PME analysis effectively takes the cash flows that have been flowing into and out of a private equity investment and matches the timing and weight of investment into a listed quoted index. As a metric, it can be used to answer questions such as:

  • What is the opportunity cost of our private equity portfolio?
  • Would we have performed better if the same allocation was put into a passive index fund?

This metric can also help you identify the alpha producing capabilities of individual managers to aid in your due diligence process.

Public Market Equivalent Methodologies

Various calculation methodologies have been developed since PME was first conceptualized. Below is a brief overview of each methodology, but you can find a more comprehensive overview of each in our Investment Statistics Guide.

PME (Long Nickels PME)

This PME result is directly comparable to an IRR and so outperformance is measured against the IRR. One shortfall of this methodology is that if a fund significantly outperforms an index, it can result in a short and a negative value.

Modified IRR (MIRR)

This is a modification of the IRR with the intention of resolving the associated issues of the finance rate and re-investment rate. The MIRR is directly comparable to the TWR of the selected benchmark over the same time period.

PME Ratio (Kaplan Schoar)

While other PME methodologies are directly comparable to an IRR, the Kaplan Schoar methodology instead produces a ratio. If the ratio is in excess of 1.0, the fund is deemed to have outperformed. Below 1.0, and it has underperformed.


Proposed by Thomas Kubr and Christophe Rouvinez at Capital Dynamics in 2003, this methodology avoids the shorting issue of the original PME methodology and is directly comparable to an IRR.

Direct Alpha

Proposed by Oleg Gredil, Barry Griffiths and Rudiger Stucke in 2014, Direct Alpha is the newest PME methodology. Contributions and distributions are discounted back to the initial cash flow date by the growth in the selected benchmark and an IIR is calculated on the present value of all cash flows. The Direct Alpha result is an absolute measure of alpha and not a relative comparable.

Picking an Index

Selecting the right index to benchmark against is as important as choosing a methodology. For example, in the above image, we can see that the S&P 500 and Russell 3000 have returned around 5%, and the example fund manager, Silvermills, generated an alpha equivalent to 13.3%.

However, this GP is actually a growth equity tech fund manager. With market capitalizations of companies listed on the S&P 500 in the tens of billions, and this manager investing at valuations much lower than that, the return profiles and risk exposures are not necessarily comparable. To better gauge the opportunity cost of this PE fund investment, and the PE managers skill, an investor may want to instead use an index comprised of tech growth stocks, such as the NASDAQ.

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.

In the eVestment 2017 Private Markets Due Diligence Survey, 73% of respondents said they use more than one index to do analysis and due diligence. Also, 34% of the respondents vary the index based on the strategy they are pursuing. To expand on this idea, let’s look at how a real pension plan might use this type of analysis.

This plan is continually evaluating how their public market equivalents are being calculated. The example plan is using PME as a way of measuring the performance across each of their buckets of money and using different benchmarks. Sometimes a weighted benchmark can also be used to identify the amount of alpha that has been generated by a manager.

Looking to calculate PME accurately and efficiently? eVestment TopQ enables you to carry out sophisticated PME analysis on private equity portfolios, funds and deals, with access to all major methodologies and over 200,000 indices for you to choose from.