The Problem With Long Nickels PME

by Michael Roth

Long Nickels was the industry’s first foray into comparing private equity to the public markets. At first glance, Long Nickels is intuitive, simple to execute, and its output is an IRR measure which is easily understood. This is likely why early results of our LP survey indicate Long Nickels is the most widely used PME methodology. Despite its widespread adoption, the Long Nickels calculation makes certain assumptions that need to be highlighted so investors understand why the calculation can be unreliable with typical private equity fund cash flows.

Long Nickels establishes a hypothetical public market fund that replicates the private equity fund’s cash inflows and outflows into a public market index. In scenario 1, I will highlight how the calculation works. In scenario 2, I will demonstrate how the calculation can break down – a situation I ran into more than I wanted to as an LP.

Scenario 1 – A Simple Cash Flow

Long Nickels works well in simple situations, such as the example below where cash has been invested but not yet distributed.

As Chart 1 shows, Fund A has invested $15 million and has an NAV of $25 million. Meanwhile, the $15 million public market investment would have an NAV of $22.2 million and a 10.8% IRR based on the public market’s returns.

When a fund has no (or relatively small) distributions, the Long Nickels calculation performs as intended and compares the fund’s performance to its hypothetical growth in the public markets.

Scenario 2 – A More Life-like Cash Flow Example

Scenario 2 looks at a more realistic cash flow example where there are multiple capital calls and distributions. The end result highlights Long Nickels’ shortcomings.

Looking at Chart 2, Fund A has generated strong returns to date and has already returned more than cost. Importantly, the fund still has a considerable NAV remaining (0.5x RVPI). Looking at the public market investment, the thing that stands out to me is that the NAV is 67% smaller than the private equity fund’s NAV!

Fund A still has four years left in its fund life but the public equity portfolio’s NAV is now at the point where Fund A’s next distribution could cause the NAV to go to 0 or even “break” the calculation because NAV goes negative. Capital Dynamics noted in a 2003 article that the Long Nickels calculation “broke” more than 20% of the time when they calculated it against historical private equity fund cashflows. As an LP, it became worrisome to use Long Nickels in quarterly reports and worry whether this is the quarter the calculation “breaks” forcing you to have a lengthy discussion about the finer points of PME with your investment board.

Why does this happen? The major shortcoming with Long Nickels is that it incorrectly uses the private equity fund’s distributions. By using these distributions, the calculation: (1) overstates the amount sold by the hypothetical public market portfolio and (2) incorporates the private equity fund’s gains, which are included in the distributions, into the public market’s performance calculation.

Final Thoughts

In theory, Long Nickels makes sense – I use my private equity cash flows to buy and sell a public market index. However, the calculation’s simplicity becomes its main shortcoming because it uses the private equity fund’s distributions to calculate what to sell from the hypothetical public market portfolio. While Long Nickels works most of the time, it is troubling that so many investors accept a performance metric that “breaks” 20% as their standard for measuring private equity to the public markets.