Making sense of PMEs

by Michael Roth

The private equity industry has always had its own way of measuring performance. Unlike a mutual fund, investors are committing to a blind pool of capital where GPs have discretion over the timing of inflows and outflows. This is why there is a difference in how you measure performance between a private equity fund and an equity mutual fund. Analyzing multiples of invested capital and IRRs – as opposed to a time weighted rate of return on public markets – allows investors to analyze a fund’s performance relative to its peers. However, if you are looking to compare a private equity fund’s performance to the public markets, you need to calculate a public market equivalent (“PME”) return measure. There are five main PME methodologies:

Long Nickels – this is the earliest PME methodology. Accounting for a certain public market index’s impact on fund cash flows (“CFs”), Long Nickels produces an IRR measure of the public markets. The technique creates a synthetic public market portfolio in an index using the private equity fund’s CFs. From the synthetic public market portfolio, an end of period net asset value (“NAV”) is generated. The private equity fund’s CFs are combined with the ending public market NAV to calculate an IRR for the public market index. If the fund’s IRR exceeds the public market’s IRR, the fund outperformed the public market.

The main caveat with Long Nickels is that it can produce a null result when the private equity fund dramatically outperforms the public market index. This occurs because the public market’s NAV is completely sold off (creating a situation where the NAV goes negative) before the private equity fund is fully liquidated. A Capital Dynamics’ study found 1 in 5 funds produce a null result.

PME+ and mPME – these two PME methodologies created by Capital Dynamics and Cambridge Associates, respectively, have very similar calculations. Their calculations descend from the Long Nickels calculation and look to account for the main flaw in Long Nickels by using a coefficient that rescales the private equity fund’s distributions so the public market NAV does not go negative.

PME+ uses a coefficient to scale the fund’s distributions so that the public market NAV remains positive. From reading several papers and articles that mention mPME, it is Bison’s understanding that Cambridge Associates uses a method similar to PME+, but their coefficient for scaling distributions varies for each CF transaction. It is noteworthy that the use of scaling coefficients by PME+ and mPME alters the actual CFs and adds a level of approximation to the performance calculation.

Kaplan Schoar – the Kaplan Schoar PME (“KS PME”) is a methodology that uses a public market index value to discount the value of the private equity funds’s CFs. The discounted cash outflows + NAV are divided by the discounted cash inflows. This produces a ratio that tells you whether the fund outperformed or underperformed the chosen public market index. A value greater than 1 means the private equity fund outperformed the index and vice versa.

The KS PME has been cited by a number of different academics as being a superior PME calculation. It does not incur the same issues as Long Nickels in regards to returning a null value. Also, the calculation looks at the ratio of outflows vs. inflows as opposed to generating an IRR, which is time dependent and is easily manipulated.

Direct Alpha – Direct Alpha measures the private equity fund’s outperformance versus a public market index. Knowing what we know today about a certain index’s return, it asks what was the money-weighted gain/loss for investing in the fund relative the index. The calculation looks at the private equity fund’s cash inflows and outflows and discounts them by the public market index’s return before generating an IRR on the net CFs.

The calculation piggy backs on the KS PME, but seeks to quantify the alpha outperformance (or underperformance) of the fund into a rate of return. For example, if the fund has a 20% IRR and the fund has a direct alpha of 6%, it implies the public market has an IRR of 14%.

Conclusion
There are advantages and disadvantages with each of these methodologies. Which method is right for you depends on how you benchmark your portfolio program, asset allocation factors such as sector, stage and geography, and/or the stage of funds you are benchmarking. The Bison Performance Calculator makes it fast and easy to measure your fund’s performance across a number of these methodologies as well as different indices. We take the manual work out of getting total return index data, tracking cash flows, and calculating PME returns. Try it free for a limited time on Bison. Click here to get started.