How PME Methodologies Measure GP Performance

Public market equivalents have been a useful gauge of manager performance thus far, but there are limitations

Selecting a fund manager can be difficult, particularly for the inexperienced or those investing in unfamiliar asset classes. The myriad of strategies available – targeting various asset classes and geographies with a wide range of risk parameters – can be mystifying for investment committees or trustees. Even for seasoned investment professionals, too. 

Given the huge range of managers and funds, placing them on a level playing-field can be very difficult. In addition, the range of benchmarks used for funds can be wide, with many unlikely to be used by the LPs selecting managers. 

In the past, LPs have looked to the public markets, or their equivalents, to drill down into fund manager performance. These PME (public market equivalents) have been a useful measure of manager contribution to performance thus far.

The basic premise of PME is to calculate the future value of each cash flow as if they were invested in a reference stock market index. There are several examples of PME, with the Long-Nickels index comparison method (ICM) being the first developed and one of the best known. Proposed by Austin Long III and Craig Nickels in 1996, the basic idea of the Long-Nickels method is that the cash flows of a fund, i.e. contributions and distributions, are invested in a stock market index and generate a net asset value (NAV) at the end of each period. The last NAV is used to calculate the IRR and this IRR is the Long-Nickels PME. For comparison, two IRRs are calculated, one is the fund IRR and the other is the Long-Nickels IRR. If the fund IRR is greater than the Long-Nickels IRR, then the fund provided excess returns compared to the stock index (alpha) and vice versa. The Long-Nickels PME is far from perfect, however, particularly when a large-scale outperformance or underperformance can affect the IRR, potentially leading to a null value.

As with many things in life, time never stands still in the world of fund performance and benchmarking. In the 2003 paper ‘Private equity benchmarking with PME+,’ Christoph Rouvinez introduced a new method of benchmarking private equity fund performance, using a coefficient lambda (λ) or a scaling factor to discount the value of distributions so that the NAV of the index matches the NAV of the fund. The PME+ returns an IRR value of discounted distributions. After that, the discounted distributions are used to calculate net cash flow and PME+ IRR. If the PME+ IRR is less than that of the fund’s IRR, the fund has outperformed the benchmark index.

One of the challenges with PME+ is that the calculations can be complex. Meanwhile, the usage of a single scaling factor ensures the calculation is sensitive to strong outperformance or underperformance. In a nutshell, PME+ suffers from the common limitations associated with IRR calculations.

There are several other PME measures of performance, such as Kaplan-Schoar PME (KS PME), which is useful to a point, but ignores the timing of cash flows – a major consideration. In general, these measures don’t go far enough for many investors to draw the conclusions they need. As studies into returns and performance measurement continued, a new, potentially better and more representative, method was established: Direct Alpha.

Direct Alpha is an important addition to the ‘toolkit’ for investors seeking a top performing manager. Read our previous article for information on Direct Alpha and the methodology behind it.