Comparing Private Equity Returns to Public Markets

High-level performance numbers like IRR and TVPI tell you whether or not a manager has performed well in the past, but the real key is to understand how they generated that value in their portfolio companies and how this compares with their proposed strategy for the new fund

Public Market Equivalents (PME) covers a variety of methodologies for benchmarking private equity returns to listed public indices.

PME Analysis

PME has the advantage of benchmarking against a known quantity.  It can be used to measure the alpha generated over and above a market return or to assess the opportunity cost of investing in private equity.  In its simplest form it can even be used to compare a private equity return figure with a more traditional time weighted return. PME can therefore be used as part of the asset allocation decision making process.

The basic concept of PME analysis is to invest the private equity cashflows into and out of a listed index.  There are a variety of different methodologies as to how best to achieve this.

First proposed by Austin M. Long and Carig J. Nickels in 1996 (A Private Investment Benchmark).   They called it the ICM method (Index Comparison Method).  Also known as the Long Nickels PME or LN-PME.

Creates a theoretical investment into the selected benchmark using the actual cash flows.  Each Contribution is invested in the index and each distribution is treated as a sale out of the index.

This results in a theoretical NAV, which is substituted in place of the actual NAV in order to calculate an IRR.

The PME result is directly comparable to an IRR and so outperformance is measured against the IRR.  Where the fund significantly outperforms the selected benchmark it can result in a short in the index and a negative value, which is not appropriate for calculating a PME result.

Modified IRR
The MIRR (Modified Internal Rate of Return) is a modification of the IRR with the intention of resolving the associated issues of the finance rate and re-investment rate.

All contributions are discounted back to the initial cash flow date by the growth in the selected benchmark.  All distributions are discounted forward to the final cash flow date by the growth in the selected benchmark.

The annualized performance can then be calculated using these two values as you would a Time Weighted Return (TWR).

The MIRR is directly comparable to TWR of the selected benchmark over the same time period.

PME Ratio
First proposed by Steve Kaplan and Antoinette Schoar in 2005 (Private Equity Performance: Returns, Persistence and Capital Flows).  Also known as the Kaplan Schoar PME or KS-PME.

Both the contributions and distributions are discounted back to the initial cash flow date by the growth in the selected benchmark.

The resultant PV of all distributions is then divided the PV of all contributions.

The PME Ratio is not directly comparable to an IRR or other measure.  Instead, if the ratio is in excess of 1.0 then the fund is deemed to have outperformed the selected benchmark and where the ratio is below 1.0 the fund is deemed to have underperformed the selected benchmark.

First proposed by Thomas Kubr and Christophe Rouvinez at Capital Dynamics in 2003, it was patented in 2010. In order to avoid the issue where PME results in a short position in the index and therefore a negative NAV, PME+ maintains the actual NAV and instead scales the distributions by a factor lambda. An IRR is then calculated on the revised cash flows.

The PME result is directly comparable to an IRR and so outperformance is measured against the IRR

Additional Tips
It is important when using PME to take account of the comparability of the chosen index with the strategy being employed by the selected private equity manager.  Very few private equity firms target the scale of companies to be found in most listed indices.

Comprehensive PME Analysis from eVestment

eVestment’s private markets solution enables GPs and LPs to quickly and easily identify private equity’s relative performance to over 200,000 public market indices.

All key PME methodologies are available to suit your specific preferences.

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