Benchmarking requires the ability to objectively generalize findings. This is why the construction of any financial benchmark is essentially the complex result of a rigorous averaging exercise.
From this perspective, the public market equivalent (PME) methodologies currently adopted for private equity benchmarking have not overcome the well-known limitations of the internal rate of return (IRR).
GPE-based benchmarking exercises not only fail formally in terms of mathematical and statistical accuracy, but also in substance. PME does not reflect the economic reality of private equity. Indeed, in this regard, it is even worse than the TRI.
PME does not represent a risk-adjusted measure. This involves an assumption of relative beta measurement on the underlying public market benchmark without clear market standards as to how to measure a private equity fund’s beta.
The widespread use of results from generalized SME benchmarking distorts the cash and equity nature of self-liquidating private funds. Without consistent underlying data – academia has failed to cover the basic statistical groundwork in this case – widespread SME-based benchmarking exercises turn what should be objective assessments into pub-after discussions office hours between fans of opposing methodologies.
Now that doesn’t mean that for one fund the PME or IRR calculation is incorrect. Rather, I believe that the use of SME and TRI should be strictly confined to the realm of single asset valuations. The IRR is a well-known shorthand for Net Present Value (NPV) calculations at a single project level. PME is a variation in relative value of this theoretical exercise and is only possible on an ex-post basis.
Equivalent public market measures (EMP)
PME has different configurations which are well detailed in industry publications. For reference, here is my simplified summary:
1. Long–Nickels PME (LN-PME)
In its original configuration, the LN-PME, which is often incorrectly described as an annualized rate, is calculated by converting contributions from the PE fund into an equivalent purchase of shares of a specific public index and subsequent distributions from the PE funds in public index sales. shares. The result is an IRR-like rate of return — in effect, performance is assessed by comparing the IRR generated by the investment in the public market to the fund’s IRR.
Despite the computational difficulties – among them high PE fund distributions producing negative SME NAVs – this is an apple-to-apple comparison and perfectly valid for single-asset analysis. But the LN-PME results have the same limitations as the TRI: they cannot be properly averaged and generalized.
The PME+ calculations sought to address the computational limitations of the LN-PME by introducing scaling factors for contributions and distributions. But they have essentially preserved both the good and the bad of the primary vocation of the SME: to serve than the public procurement IRR. Greater calculation accuracy came at the expense of accurate cash flow matching.
3. Kaplan–Schoar SME (KS-SME)
The latest version KS-PME dissolves the IRR connection and transforms the PME into a ratio. The numerator is the sum of the compound value of distributions plus the actual net asset value of the fund, and the denominator is the sum of the compound value of contributions. The compound factors are the relevant ex post returns of the chosen public market index. A ratio greater than one indicates outperformance. Like the LN-PME, the KS-PME gives a perfectly valid apple-to-apple comparison for the single asset examined.
SME Generalization Failures: Insufficient Benchmarking
In any statistical exercise, the robustness of the result, even as simple as an average, is influenced by how the experiment is defined and the population that is observed, sampled and measured.
If the IRR cannot be properly averaged, so can the PME metrics.
- The IRR and PME do not properly account for the amounts and timing of investments and divestments. As a result, the averaged measurements lack consistency.
- IRR and SMEs are impacted by the use of subscription lines and other financing tools. The TRI anticipates the impact better in this case, usually with a higher rate, while SME swings are unpredictable and subject to market volatility.
But what about the short-term volatility of public markets? Volatility will likely exert a random influence on the compound rates that determine the MEP. In some cases, this influence can be significant. Consider, for example, the V-shaped crisis of March 2020 and its effect from an SME perspective on expected distributions and contributions during this period.
The low representation of SMEs as a benchmarking tool
But more than the noise of volatility, what SME mechanics really miss is the economic substance of private equity managers’ investment styles.
I managed institutional investments in public equity markets with an unconstrained mandate and an annualized target of 8%. Whether the markets were on a bull run didn’t concern me much. My mandate was to make at least 8% and no less. When I broke through the threshold, I looked to reduce risk and reduce beta exposure and sell. Of course, I knew investors would complain if I didn’t beat the market, but given my tenure, I relied on two key Warren Buffett rules:The first rule of investing is not to lose. And the second rule of an investment is to remember the first rule, and those are all the rules that exist.”
Due to behavioral biases, investors often forget the purpose of an investment style. Private equity is absolute return. This is reflected in the traditional 8% hurdle rate of the “promote” incentive. Moreover, a recent academic study posed a crucial question: “What are the private equity firms saying?“The survey of GPs managing over $750 billion found that their LPs are more focused on absolute returns. Yet GPE measures relative performance and does not capture the full dynamics of private market investments from the perspective of a GP or LP
Since PME measures the multiple wealth effect of an investment in the private equity fund relative to the index, the valuation of private equity funds based on the implicit investment of the PME closet-indexing would distort the intrinsic absolute return characteristic of the PE and the return expectations of the LPs. Generalists would need to time the market to beat it – and in this case, they could run the risk of not generating the targeted total return within the stated time frame.
Proper benchmarking tools must take into account all the investment characteristics of private equity – cash invested and returned with a total return objective. The time-weighted, duration-based DaRC approach is the only unbiased solution that would meet the GP and LP PE assessment requirements.
“Sold, guadagna and repentedsaid one of my former bosses, a career trader. “Sell, make money and repent!” The English-speaking world would say, “Sell in May and go”.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: © Getty Images / Nancy Naughton / 500px
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