Assessing Alpha in Private Equity Returns with Public Market Equivalent Analysis

Assessing Alpha in Private Equity Returns with Public Market Equivalent Analysis
May 2nd, 2018

With private equity experiencing strong distributions in recent years (figure 1), investors have been quick to re-invest to maintain target allocation goals and also capture future returns. This is evidenced by the strong fundraising environment – PEI reported that 2017 global private equity fundraising totaled $411bn, the highest annual total since 2008.


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

Why are investors using Public Market Equivalent analysis?

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, investors need to ensure a clear understanding of their portfolio performance relative to other asset classes when evaluating future allocations to private equity strategies.

Public market equivalent (PME) analysis is also being used by investors during their due diligence processes to benchmark and compare managers’ performance. As PME analysis compares performance against a public market index, it provides a more measurable, continuous benchmark than the blindpool peer benchmarks commonly used. It it also used as one technique to distinguish value creation: has a private equity fund manager excelled in market timing and ridden the economic wave, or have they delivered outperformance through their skill in deal selection and/or operational expertise?

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 2018 Private Markets Due Diligence Survey, we found that 72% of respondents carried out public market equivalent (PME) analysis and 52% 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.


Learn more about each methodology in the PME section of our investment statistics guide.


While many methodologies exist, there is not one industry standard. In eVestment’s 2018 survey of investors and consultants, we found that 42% of respondents use more than one methodology and use is spread relatively evenly across the key methodologies.

As shown in figure 3, the most popular PME methodology used by respondents to the 2018 eVestment survey was Kaplan-Schoar, at 48% using it, followed by PME+ at 42% of respondents using this. Direct Alpha is the newest of the methodologies, yet still used by a significant proportion of respondents.

Figure 3. Investors and consultants use of public market equivalent analysis, 2018, eVestment

For investors, there is no “right” answer to which methodology should be used: it highly depends on why they 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? Investors must think about these questions and evaluate the nuances of each methodology in depth to decide which methodology/s are most suitable.

For private equity fund managers, this data highlights that you need to be able to calculate how your performance compares to a variety of public market equivalent methodologies in order to ensure you can view it in the same way as your investors.

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 Private Markets’ 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 2018 Due Diligence Survey, it was clear investors are applying this very tailored approach to benchmarking private equity to public markets –  46% used more than one index to do analysis and due diligence and many stated they vary the index based on the strategy they are pursuing (2018 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 Private Markets, 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. The performance analytics functionality of eVestment Private Markets includes a robust yet easy-to-use PME module that allows users to compare performance of funds and track records to indices and methodologies of their choice – and even create blended benchmarks with specific weightings.

Learn more about how you can efficiently calculate Public Market Equivalents here, or email us at privatemarkets@www.evestment.com if you’d like to speak to one of our specialists about eVestment Private Markets.

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