Does private equity outperform public markets? A simple question without an answer that doesn’t have several caveats and complications. In the first two articles in this three-part series we examined the historical returns to the private equity industry and made several references to performance in the public markets. This third installment is a two-part article. The first portion provides background on what makes public/private equity comparisons tough and outlines some of the more common methods used to make equitable comparisons. The second portion (starting on page 31) is an article by Christophe Rouvinez of Capital Dynamics that offers improvements to the current methods of making public/private market comparisons.
The internal rate of return (IRR) is the most common way of measuring performance in the private equity industry. Long an industry practice with practical and defensible reasons, the IRR is not often used in other asset class comparisons. The IRR takes the time value of money into account and thus takes the timing of investment decisions into account when calculating performance. If you are not familiar with the IRR methodology a full description of methodology is available in the Investment Benchmarks Report on Performance published annually by Thomson Venture Economics (publisher of Venture Capital Journal) or in the methodology section at www.ventureeconomics.com.
The IRR is the best measure of returns for private equity fund managers in that it takes timing (time value of money) into account. This is crucial because the investment manager (“general partner”) has total control of the cashflows between the LP and the GP. For example, the GP controls when to raise a fund, when to take capital calls, when to invest in portfolio companies, when to exit and when to distribute proceeds. So, the total cashflow timing is in the GP’s hands and, thus, its timing decisions should be rewarded or penalized. The LP uses IRR to determine how well the investment manager is doing in managing the capital it has invested for the LP.
Contrast this to a typical investment manager in the public markets. For example, an investment manager has little control over whether his or her clients choose to withdraw or add money to their account, so we don’t want to reward or penalize the manager for cashflow decisions out of his or her control. It is for this reason that public market managers are usually benchmarked using a time-weighted return (TWR).
The time-weighted return (a misnomer in that time is totally taken out of this calculation) is also known as a geometric average, compounded annual growth rate or the compounded annual return. This is the calculation cited when looking at index returns in the public markets. If we look at the returns to the S&P 500 over a period of time, we take the ending value, divide it by the beginning value and then take the nth root of the result and subtract 1 to get a compounded annual return. Another way of doing this is to take the returns for each day, month or other period of time and multiply them (1+return), then take the nth root to get a time-weighted return.
The big difference in the IRR and TWR examples above is that the S&P 500 assumes that you have a buy-and-hold strategy-that is, buy the S&P index at the beginning of the period you are measuring and sell the index at the end of the period. There are no cashflows in between, so that timing is not part of the calculation.
Trying to use the TWR for an individual fund can give very different results. Figure 1, calculates cumulative IRR and TWR results for an actual 1996 vintage year fund. The end results as of 12/31/1999 are large-17.9% using the IRR and 9.2% using the TWR.
If the difference between an IRR and TWR is so large, how can we reconcile the two? One approach is to simply calculate a TWR for the industry but assume that at higher levels of aggregation that the two become comparable as the timing decisions become less relevant over long periods of time and over large numbers of funds. That is the assumption we made in the first two articles when talking about public/private returns comparisons. As long as we don’t measure returns for an individual fund this way, at high levels of aggregation, the TWR becomes more relevant.
This is something that Venture Economics publishes and makes available via its performance database and investment benchmarks reports, in addition to the IRR it usually reports. But this method assumes that if you want a quarterly compounded TWR for private equity investment, you have to have quarterly values. As anyone in the industry knows, quarterly valuations, while having some value, do not have the volatility that public market returns have, thus the TWR has one weakness: Valuations are not accurate enough or frequent enough to make a public market index comparison to private equity truly apples to apples.
PME or Index Method?
To make the comparison apples to apples, the “index method” or “private market equivalent” (PME) method was developed. It attempts to reconcile the IRR with the TWR by simply assuming that you invest the cashflows invested in private equity into a public market index. In 1995, Austin Long, vice president for Private Investment at UTIMCO, a spin-off investment firm of the University of Texas, and Craig Nickles, a UTIMCO investment officer, circulated an unpublished manuscript entitled: “A method for Comparing Private Capital Internal Rate of Return with Public Market Index Returns.” A similar method had been in use by Bannock Consulting for calculating public/private returns in Europe in the early 1990s. This method has been published by VE since 1996 in its Investment Benchmarks Report in the chapters on public/private asset comparisons. In Europe the method is called the “comparator method” and is published by Thomson Venture Economics in its European Investment Benchmarks Report and in the performance figures published by Thomson Venture Economics for the European Venture Capital Association.
This new method attempts to create a comparable public/private performance metric by creating a series of synthetic cashflows by assuming that the capital invested in a private equity portfolio was invested into a public stock market index instead. These invested flows are compounded to a terminal value to create a synthetic ending period net asset value (NAV). That NAV is then combined with the original private equity cashflows to calculate an IRR for the public market index.
There are some serious caveats in this method.
1. It assumes that investments in the stock market would be held as long as the original investment in private equity.
2. The total return calculated for most public stock indices assumes dividends are reinvested, while the typical private equity fund distributes proceeds.
3. The most problematic issue is that under certain conditions, the return to private equity may be so large in proportion to the return to a stock index that the stock index equivalent is mathematically dominated and will yield a 100%, which is not intuitive or sensible. This often makes investment managers look at this method with raised eyebrows as to its accuracy.
Those issues notwithstanding, interest in this method persists and many ways have been suggested to this author for improving the PME (see link below). The accompanying article contributed by Christophe Rouvinez, a partner at Capital Dynamics, provides a method that tries to improve upon the index method (PME) by dealing with the most problematic of these issues-the 100% return that gives everyone pause in using this method.
The bottom line is that IRR is the best relevant calculation for measuring individual fund performance, but when looking at asset class comparisons, the IRR becomes problematic and either a TWR or Index Method PME approach may be used.
Jesse Reyes is vice president of research at Thomson Venture Economics (publisher of VCJ).
PART 1 of 3: Put Performance Into Perspective
Click here for Put Performance Into Perspective, which appeared in the June 2003 issue of Venture Capital Journal.
PART 2 of 3: All Funds Aren’t Created Equal
Click here for All Funds Arent Created Equal, which appeared in the July 2003 issue of Venture Capital Journal.
Follow this link for “Private Equity Benchmarking with PME+,” written by Christophe Rouvinez of Capital Dynamics, which appeared in the August 2003 issue of Venture Capital Journal.