In March, Connecticut-based secondaries firm Landmark Partners published a white paper on a hot topic in private equity: how to draw more meaningful conclusions about private equity returns.
One tool that has become more prevalent in performance measurement recently is the public market equivalent (PME). This metric is intended to provide a helpful comparison with a relevant group of publicly-listed companies between the times of drawdowns and distributions, the idea being to weed out the impact of general market movements.
Some limited partners, fund managers and consultants have been using some sort of benchmark along these lines since 1995. But their use has proliferated in the last couple of years, with the most common now being the Index Comparison Method (ICM), PME Plus and mPME .
But according to Barry Griffiths, vice president and head of quantitative research at Landmark, all of these methods have their drawbacks.
“All of the approximate methods are pretty good for most cases, but they all have some cases where they can lead to errors or incorrect outputs,” he says. “Nobody really claimed that the ICM or PME+ actually solved for alpha given a formal portfolio model. It was a heuristic approach that seemed like it ought to give a reasonable, usable answer.”
According to Landmark, the problem is not that there’s a lack of methods for comparing returns for liquid and illiquid assets. The problem is there are too many, each giving conflicting answers.
“When I talk to practitioners about using PME as a way of trying to disentangle manager skill from the ups and downs of the market, they always say, ‘I get really funny answers. What do they mean?’” says Griffiths.
Indeed, even experienced investors struggle to determine which PME calculation method is the most accurate for a given set of performance data.
“Not many investors are well versed enough to compare the available methods and understand why certain frameworks are very robust and why [other] methods lead to errors,” says Ian Charles, a partner at Landmark.
“Making sure you’re running the calculation correct is important, but just as important is identifying the right benchmark. What is the right size, industry, region and leverage to replicate the risks taken by this fund? Very few funds look like the S&P 500, so using the correct PME framework without an appropriate benchmark will still lead to investment selection errors.”
All of which explains why Landmark has come up with its own method for PME calculation, called Direct Alpha. This involves a two-step calculation that uses the future value (at final valuation time) of each contribution and distribution, according to the reference benchmark, and the internal rate of return for that sequence of future-valued cash flows.
It’s similar to Kaplan and Shoar’s Public Market Equivalent, which was first published in 2005 by Steven Kaplan, the Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business, and Antoinette Schoar, Professor of Entrepreneurial Finance at MIT Sloan School of Management – but more straightforward, according to Griffiths. “The Direct Alpha method is the simplest because you only have to do one thing, which is calculate future values,” says Griffiths.
Unlike other methods, it also calculates an exact rate of return of outperformance relative to the selected benchmark, he adds. “We hope that practitioners will become more aware of how these things work, and they’ll be able to get useful results that are more nearly correct and less often misleading.”