Benchmarking requires the flexibility to generalize results objectively. Therefore, the event of a financial benchmark is basically the complex results of a rigorous averaging process.
From this attitude, the currently used public market equivalent (PME) methods for benchmarking private equity haven’t overcome the known limitations of the interior rate of return (IRR).
Benchmarking exercises based on PME fail not only in formal terms of mathematical and statistical rigor, but in addition in content. PME doesn’t reflect the economic reality of personal equity investments. In this respect, it’s even worse than the IRR.
PME isn’t a risk-adjusted metric. It implies a relative beta measurement assumption over the underlying public market benchmark with no clear market standards for measuring the beta of a PE fund.
The widespread use of generalized PME benchmarking results misrepresents the money and equity nature of self-liquidating private funds. Without consistent underlying data—the science has did not convey the statistical underpinnings on this case—generalized PME-based benchmarking exercises turn objective evaluations into after-market barroom discussions amongst adherents of opposing methodologies.
This isn’t to say that calculating the PME or IRR is unsuitable. Rather, I consider that using PME and IRR ought to be strictly limited to the valuation of individual assets. The IRR is a well known shorthand for calculating the online present value (NPV) at the person project level. The PME is a relative value variant of this theoretical exercise and is just possible on an ex-post basis.
Public Market Equivalent (PME) measures
PME offers several configurations which might be described intimately in industry publications. For reference, here is my simplified summary:
1. Langnickel-PME (LN-PME)
In its original configuration, the LN-PME, often incorrectly described as an annualized rate of interest, is calculated by converting contributions from the PE fund right into a corresponding purchase of shares of a selected public index after which converting distributions from the PE fund into sales of shares of the general public index. The result’s an IRR-like return – in reality, performance is measured by comparing the IRR generated by investing in the general public market to the IRR of the fund.
Despite the computational difficulties – including large PE fund distributions that lead to negative PME NAVs – this can be a direct comparison and is perfectly valid for single asset evaluation. However, LN-PME results suffer from the identical limitations because the IRR: they can not be properly averaged and generalized.
2. PM+
The PME+ calculations attempted to deal with the calculation limitations of the LN PME by introducing scaling aspects for contributions and distributions, but essentially retained each the great and bad points of the PME’s original purpose: to serve because the IRR of the general public markets. Greater calculation accuracy was achieved on the expense of an accurate match of money flows.
3. Kaplan-Schoar PME (KS-PME)
The latest KS-PME version breaks the IRR link and converts the PME right into a ratio. The numerator is calculated because the sum of the compound value of distributions plus the actual net asset value of the fund, and the denominator because the sum of the compound value of contributions. The compounding aspects are the relevant ex-post returns of the chosen public market index. A ratio above one indicates outperformance. Like the LN-PME, the KS-PME allows for a wonderfully valid comparison between the person assets into account.
Generalization deficiencies of PME: Benchmarking inadequacy
In any statistical study, the robustness of the result – even for such a straightforward average – is influenced by how the experiment is defined and which population is observed, sampled and measured.
If the IRR can’t be properly averaged, the identical applies to PME metrics.
- Neither IRR nor PME properly account for the amounts and timing of investments and divestments. As a result, the averaged metrics lack consistency.
- Both IRR and PME are affected by means of subscription lines and other financing instruments. The IRR on this case anticipates the impact higher, normally with the next rate of interest, while the PME fluctuations are unpredictable and subject to market volatility.
But what about short-term volatility in public markets? Volatility is prone to have a random impact on the compound interest that determines the PME. In certain cases, this impact might be significant. For example, consider the V-shaped crisis of March 2020 and its impact from a PME perspective on distributions and contributions planned for that period.
Weak representativeness of PME as a benchmarking tool
But what the PME mechanics really fail to acknowledge isn’t just the volatility noise, however the economic substance of the PE managers’ investment styles.
I managed institutional investments in the general public equity markets with an unconstrained mandate and an annualized goal of 8%. I didn’t care much whether the markets were up. My mandate was to return at the least 8% and no less. When I crossed the brink, I attempted to cut back risk, reduce beta exposure, and sell. Of course, I knew that investors would complain if I didn’t beat the market, but given my mandate, I relied on two key rules from Warren Buffett: “The first rule of investing is: Don’t lose. And the second rule of investing is: Don’t forget the first rule. Those are all the rules there are.“
Due to behavioral biases, investors often forget the aim of an investment style. Private equity is about absolute return. This is expressed in the standard 8% minimum return of the “promoter” incentive. In addition, a recent academic study asked a critical query: “What do private equity firms say they do?“The survey of GPs managing greater than $750 billion found that their LPs are more focused on absolute returns. However, the PME measures relative performance and doesn’t capture the complete dynamics of personal market investing from either a GP or LP’s perspective.
Because the PME measures the wealth multiplier effect of investing within the PE fund versus the index, valuing PE funds based on the implied characteristics of the PME would distort the inherent absolute return of the PE and LPs’ return expectations. GPs would must time the market to beat it – and in that case, they risk not achieving the targeted total return inside the required time-frame.
Appropriate benchmarking tools should consider all investment characteristics of personal equity – money invested and money returned with the target of total return. The time-weighted duration-based DaRC approach is the one unbiased solution that meets the PE valuation needs of each GPs and LPs.
“,” one in all my former bosses, knowledgeable trader, used to say. “Sell, make money and regret it!” In the English-speaking world they might say, “Sell in May and walk away.”
If you liked this post, don’t forget to subscribe.
Photo credit: © Getty Images / Nancy Naughton / 500px
