One big challenge faced by private equity investors is the benchmarking of performance with other asset classes. A major issue concerns the difference in return methodology employed: Private equity performance is measured in terms of internal rate of return (IRR), whereas other asset classes are characterized by time-weighted rates of return (TWR), so that a straight comparison is problematic.
Another prominent concern is the bias induced by the fact that private equity net asset values are determined by the fund managers themselves, as opposed to observed on a third-party marketplace.
The concept of public market equivalent (PME), or the Index Method, developed in the industry in the mid 1990s, offers a simple solution to the benchmarking problem. Unfortunately, the methodology sometimes produces dubious returns, or in some worse cases no benchmark at all, which makes it unreliable for a majority of purposes.
The Difference Between TWR and IRR
TWR represents the return that an investor achieves over some period of time, where each time interval carries the same weight independent of the amount of money invested. IRR is the interest rate that makes net present value of all cash flows equal zero. For an investor purchasing a single stock and selling it again after a given time interval, IRR and TWR are identical.
IRR, however, involves the computation of present value, and, unlike TWR, is very sensitive to both timing and size of cash flows. It becomes a useful measure of performance when investments and divestments are not regular, as when investing in private equity funds. IRR is also called a cash- or dollar-weighted return, as it corresponds to the return obtained for a given cash flow pattern where each dollar carries the same weight.
When To Use TWR or IRR
TWR captures the rate of return actually earned by the portfolio manager, while IRR captures the rate of return earned by the portfolio owner. From an investor perspective, IRR should be used for assessing private equity investment performance because it corresponds to the actual return that the investor achieves. The IRR computed with the cash in- and out-flows of a fund corresponds to an overall rate of return of all investors, depending on the various entry and exit points. This measure, however, is not suitable for evaluating the performance of the portfolio manager of an open-end fund, for this manager has no control over the timing and size of deposits and withdrawals made by the investors. In this case, TWR measures the performance of the portfolio manager independently of the actions of the investors, because it is time-weighted.
Should PE Managers Use TWR?
There are two major reasons why using TWR is problematic for assessing private equity fund manager performance. Firstly, the investment process for private equity funds differs substantially from processes associated with other types of funds, as the capital committed to the private equity fund is invested over several years and the fund’s subsequent distributions are irregular in terms of size and frequency. Unlike open-end investment vehicles, most private equity funds are closed-end funds where the managers fully control a fixed pool of capital and the associated investment process. Thus, the fund manager’s timing of investments and divestments is a major component of the value generation with private equity investments.
Since TWR does not capture cash-flow timing, it is an inappropriate benchmark for evaluating private equity fund manager performance. As dollar-weighted returns are sensitive to the timing of cash flows, IRR is a better measure to characterize their long-term performance.
A second point mitigating the use of TWR for the private equity asset class is that the computation of periodic returns invariably involves using reported net asset value (NAV) of the fund over time. As an accounting quantity both determined and reported by the managers, NAV suffers by nature from valuation bias. To its big advantage, long-term IRR is a cash-on-cash measure independent of NAV development.
Since IRR and TWR are different return measures and only IRR seems to be the right way to characterize the returns obtained by private equity managers, it would be helpful if some IRR could be assigned to public markets to allow for comparison. Public Market Equivalent (PME) is an index return measure, which is adjusted to reflect the irregular timing of cash flows actually experienced with private equity. It corresponds to the dollar-weighted return that would have been achieved by investing in an index at the same time when the private equity fund makes a capital call and by selling index-shares whenever the fund distributes capital back to investors. This investment strategy aims to replicate the irregular investment and divestment pattern of private equity investing so as to allow for an approximate comparison of return.
Since PME is based on the same cash in- and outflows of the private equity fund, it seems confusing that there might be a difference in return. Actually, the difference comes from the net result of the investment and divestment processes in the index-tracking fund, which either yields a positive (public market shows higher performance) or a negative balance (public market shows lower performance). That final balance alone is responsible for the IRR difference. Details of computations are available in the preprint by Austin Long and Craig Nickles.
PME: The Good
PME shows a very important quality: It is simple and takes no more than a few minutes to understand how it works. It can be directly compared to the IRR of the private equity fund with the corresponding cash flow pattern and, hence, conveniently provides for apples to apples comparison. For investors not familiar with IRR, the comparison can also be quantified in terms of multiple of investment returned.
PME: The Bad
One has to be careful with the choice of a benchmark index, as only total return indexes make sense for the analysis. Using for instance the S&P 500 as a benchmark while ignoring dividend payments might reduce PME by several points and distort the result of the comparison.
Despite being based on cash flows only, PME still depends on NAV when the fund remains not fully liquidated and the NAV is different from zero at the end of the time interval. In those cases, the benchmarking actually reduces to the comparison of the end balance of the index-tracking fund to the NAV of the private equity fund, placing more emphasis on the latter number and relying indirectly on the assumption that the private equity investor can immediately exit the fund at that value. This is why PME is generally used to benchmark the performance of mature funds, where the non-liquidated NAV is small fraction of the total distributions.
PME: The Ugly
As pointed out by Long and Nickles in their original work, a private equity investment outperforming the index is likely to yield a negative final value for the investment in the index-tracking fund. This is best illustrated with Figure 1, which represents the cash flows obtained from selecting the entire vintage 1985 of the Venture Economics private equity database and the cash flows of the corresponding S&P 500 total return public market equivalent. The reported private equity NAV at September 30, 2002, reads $280million, whereas the corresponding index-tracking fund balance at the same date amounts to $-6,315million, clearly indicating private equity out-performance. The IRR of the two patterns are 25.1% for private equity and 1.9% for the S&P 500 PME, of which the latter intuitively looks really small given the performance of the S&P 500 over that period.
A negative index-tracking fund balance means that the investor would have had to sell all his shares and even run a short position to match the private equity distributions. As can be checked on Figure 2, which shows the numbers of index shares a function of time for the PME of vintage 1985, the number of shares is negative from 1993 onwards. Over that period, the exposure of the investor is equivalent to running a short position in the index. Looking at the evolution of the cumulative total value (sum of all distributions and current net asset value), it becomes obvious how the exceptional performance of the late 1990s is actually working against him. From 2000 onwards he would be making huge gains due to the 2000 to 2002 market decline. This shift from a long to a short position completely spoils the benchmarking process and is at the origin of a low PME in that case. A further direct consequence of the short position is that any correlation analysis based on PME is erroneous.
Things can even get worse. Depending on the cash flow pattern, it might even happen that the negative balance at the end of the period causes the IRR to be undefined, as there is simply no discount rate which brings net present value to zero.
The problem is that these situations occur not so infrequently. More than one out of five of the private equity funds that we benchmarked utilizing this methodology generated short index exposure through the life of the investments. Only a few funds yielded PME cash flow patterns with undefined IRR.
The beauty of PME lies in the simplicity of the assumptions and the transparency of the method. Any amendment should aim to preserve these two characteristics, while avoiding the unpleasant issue with the short exposure.
A very simple way of preventing negative balances -at least at the end of the period-is to redeem a constant proportion of the distributions instead of the full amount. Using a fixed proportion over time ensures that the overall cash flow pattern is preserved. The smaller the scaling factor, the longer the money is staying in the fund and the longer the balance is going to stay positive. In extreme cases when the public market is showing much lower performance than the private equity fund, it might even be necessary to use a small negative number transforming distribution into further draws to make sure that the method is well defined and yields a positive balance under all circumstances.
The optimal proportion is obtained by scaling down distributions until the end balance matches the final private equity NAV. Such a choice is not arbitrary, as it ensures a similar level of exposure in the future. This is best illustrated in Figure 3, where all divestments from the index-tracking fund have been re-scaled to 73.5% of vintage 1985 distributions. The process yields a cash flow pattern similar to the private equity one, with an end balance matching private equity NAV. The corresponding public market IRR amounts to 14.4% and is this time truly representative of the performance of long U.S. public equity markets for that period.
Figure 4 shows the running number of index tracking fund shares, which remains positive over the entire period. As a result, one can verify that the cumulative total value for both public and private equity showed positive returns from 1993 to 2000, and flat or negative returns from 2000 onwards, as one would have expected for those markets.
Since the amended PME computation that we have introduced here aims to preserve the long (or positive) exposure to the benchmark asset class, we chose to name it PME+. Notice that although the PME+ scaling tends to preserve the sign of the exposure and ensures a positive end balance, it does not guarantee that the exposure stays positive over the entire investment period. Only one of the private equity funds that we have benchmarked with PME+ so far has shown a few quarters with negative exposure, whereas IRR was always well defined for all PME+ cash flow patterns.
Does Private Equity Outperform Public Equity?
The same analysis for the S&P 500 total return index and the pooled data corresponding to the entire private equity market from 1980 to 2000 yields 14.4% IRR for private equity and 9.2% for PME+, indicating an overall 5% premium for illiquidity. The choice of the S&P 500 total return is motivated here by its wide acceptance as a benchmark for the performance of U.S. public equity markets, as opposed to its relevance to the private equity market.
Figure 5 gives a breakdown of the results by vintage year, which clearly shows that this premium fluctuates widely over time, and even turned out to be strongly negative for vintage 1982. It is important to note that this premium stands for the overall private equity yield pick-up, independent from the manager, who plays an important role in the generation of higher returns for alternative asset classes.
The PME+ tool provides a reliable framework for the comparison of private equity returns with returns of other asset classes. The major objection to the approach, namely that the cash flow patterns are not exactly matching, is mitigated by the fact that at least timing, in-flows and a fixed proportion of out-flows are the same, which seems to be the minimum that can be relaxed to fix the benchmark. The results presented in the last section are shown for illustrative purposes and could easily be refined to better characterize the performance of venture capital, buyout and mezzanine funds with respect to specific indexes, or to estimate the excess yield obtained with top quartile managers.
Christophe Rouvinez is a partner in Capital Dynamics, an asset management firm that specializes in private equity. Capital Dynamics has offices in Zug, Switzerland and New York.
* Austin M. Long and Craig J. Nickles, A Private Investment Benchmark, Preprint, February 1996
* Venture Economics, 2000 Investment Benchmarks Reports: Venture Capital, Summer 2000, Bannock/Long/ Nickles/Coller Public Market Equivalents pg. 267
* VentureXpert, Cash Flow Reports as per 09/30/2002