Assessing Alpha in Private Equity Returns with Public Market Equivalent Analysis
While private equity fundraising was certainly challenged in 2020, down 19% from 2019 according to data from PEI, what will concern institutional investors more is how their existing private investments performed through the volatile year.
Private equity is primarily a return enhancer, rather than a risk diversifier, and investors need to ensure a clear understanding of their portfolio performance relative to other asset classes. This is particularly important in today’s market where overall allocations to private equity from institutional investors are at an all-time high according to data from McKinsey and CEM Benchmarking.
Blind pool peer benchmarks have traditionally been the main tools used by investors to evaluate performance from private equity managers, but today’s data-driven LPs are now turning more and more to public market equivalent analysis for this insight.
Why are investors using Public Market Equivalent (PME) analysis?
Private fund managers often justify their fees by pointing to their track records and claiming that by investing in private companies they are delivering superior returns that are uncorrelated to public markets. But according to research from Vanguard, using data from 1980 through 2012, only the top quartile of private equity returns have materially outperformed public markets.
Public market equivalent (PME) analysis gives context to a fund manager’s performance by comparing it against a public market index. It provides a more measurable, continuous benchmark compared to blind pool peer performance datasets.
Investors are becoming increasingly sophisticated in their approach to evaluating private equity outperformance – in the eVestment 2019 Private Markets Due Diligence Survey, we found that 61% of institutional investor respondents viewed PME analysis as an important part of the due diligence process.
All that said, the effectiveness of PME analysis can depend heavily on the PME calculation methodology used and also the index that the fund manager’s track record it is benchmarked against.
Public market equivalent methodologies in practice
Since the PME methodology was first proposed by Austin Long and Craig Nickels in 1996, “Long Nickels PME”, various calculation methodologies have been developed to counter some of this methodology’s issues.
The current mainstream methodologies are Long Nickels PME, Modified IRR, PME Ratio (or Kaplan Schoar), PME+, and Direct Alpha. These vary from being directly comparable to time weighted returns of public market indices, to being a ratio that indicates the level of outperformance acquired. While many methodologies exist, there is not one industry standard.
The importance of index selection
Selecting the right index to benchmark against is as important as choosing a methodology. Below we see how an average buyout deal compares to the market caps of three common public indices. The significant differences in median market cap demonstrate how important it is to pick the index that most closely aligns with the deal sizes of the track record being analyzed.
To further illustrate this, we’ll use the track record of a fictitious private equity manager, Silvermills Capital, carrying out the analysis in the TopQ+ PME module. In the image below, the S&P 500 and Russell 3000 have been included as indexes and we can see that they have returned around 5%. In comparison, Silvermills Capital generated an alpha equivalent to 13.3%, calculated using the Direct Alpha methodology.
On this basis, it appears that Silvermills Capital has vastly outperformed the index.
However, in reality this GP is focused on growth equity tech investments. With S&P 500 companies being in a diverse range of industries, and having market capitalizations in the tens to hundreds of billions – is this still an accurate comparison? With this manager investing in different sectors at valuations much lower than those of S&P 500 and even Russell 3000, the return profiles and risk exposures are not necessarily comparable. To better gauge the opportunity cost of this PE fund investment, and the PE manager’s skill, an investor may want to instead use an index with a heavier weighting of tech stocks and a lower average market capitalization.
By comparing a growth manager to the NASDAQ instead of just the S&P 500 or the Russell 3000, we can see that the alpha is not as high as 13.3%, but it is still material at 11.8%. This shows the importance of using the correct indices when using your PME to find alpha.
Evaluating private equity returns using public market equivalent analysis undoubtedly adds value and represents a powerful tool in the due diligence and performance measurement toolkit. However, as we have shown, the effectiveness of its ability to provide meaningful insight relies heavily on which methodologies and indices you use.
What is also clear is that with the widespread adoption of the measurement by the investor community, private equity fund managers need to understand its application and how their portfolios look compared to PME metrics, not just IRR and TVPI.
Sophisticated analysis like this can be time-consuming and prone to error without sophisticated tools. The performance analytics functionality of TopQ+ includes a robust yet easy-to-use PME module that allows users to compare performance of funds and track records to indices and methodologies of their choice – and even create blended benchmarks with specific weightings.