Private Equity Benchmarking with PME

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                             Private Equity Benchmarking with PME+
                                          By Christophe Rouvinez, Capital Dynamics

                One big challenge faced by private equity of return earned by the portfolio owner. From an
          investors is the benchmarking of performance with investor perspective, IRR should be used for assessing
          other asset classes. A major issue concerns the differ- private equity investment performance because it cor-
          ence in return methodology employed: Private equity responds to the actual return that the investor
          performance is measured in terms of internal rate of achieves. The IRR computed with the cash in- and
          return (IRR), whereas other asset classes are charac- out-flows of a fund corresponds to an overall rate of
          terized by time-weighted rates of                                               return of all investors, depend-
          return (TWR), so that a straight           THE FUTURE OF                        ing on the various entry and exit
          comparison is problematic.                                                      points. This measure, however,
                Another prominent concern
                                                     PERFORMANCE                          is not suitable for evaluating the
          is the bias induced by the fact          Part 3 of a 3-part series              performance of the portfolio
          that private equity net asset val-                                              manager of an open-end fund,
          ues are determined by the fund managers themselves, for this manager has no control over the timing and
          as opposed to observed on a third-party marketplace.     size of deposits and withdrawals made by the investors.
                The concept of public market equivalent (PME), In this case, TWR measures the performance of the
          or the Index Method, developed in the industry in the portfolio manager independently of the actions of the
          mid 1990s, offers a simple solution to the benchmark- investors, because it is time-weighted.
          ing problem. Unfortunately, the methodology some-
                                                                      Should PE Managers Use TWR?
          times produces dubious returns, or in some worse
          cases no benchmark at all, which makes it unreliable           There are two major reasons why using TWR is
          for a majority of purposes.                              problematic for assessing private equity fund manager
                                                                   performance. Firstly, the investment process for pri-
                           The Difference
                                                                   vate equity funds differs substantially from processes
                     Between TWR and IRR
                                                                   associated with other types of funds, as the capital
                TWR represents the return that an investor committed to the private equity fund is invested over
          achieves over some period of time, where each time several years and the fund’s subsequent distributions
          interval carries the same weight independent of the are irregular in terms of size and frequency. Unlike
          amount of money invested. IRR is the interest rate that open-end investment vehicles, most private equity
          makes net present value of all cash flows equal zero. funds are closed-end funds where the managers fully
          For an investor purchasing a single stock and selling it control a fixed pool of capital and the associated
          again after a given time interval, IRR and TWR are investment process. Thus, the fund manager’s timing
          identical.                                               of investments and divestments is a major component
                IRR, however, involves the computation of pres- of the value generation with private equity invest-
          ent value, and, unlike TWR, is very sensitive to both ments.
          timing and size of cash flows. It becomes a useful             Since TWR does not capture cash-flow timing, it
          measure of performance when investments and divest- is an inappropriate benchmark for evaluating private
          ments are not regular, as when investing in private equity fund manager performance. As dollar-weighted
          equity funds. IRR is also called a cash- or dollar- returns are sensitive to the timing of cash flows, IRR is
          weighted return, as it corresponds to the return a better measure to characterize their long-term per-
          obtained for a given cash flow pattern where each dol- formance.
          lar carries the same weight.                                   A second point mitigating the use of TWR for the
                                                                   private equity asset class is that the computation of
                   When To Use TWR or IRR
                                                                   periodic returns invariably involves using reported net
                TWR captures the rate of return actually earned asset value (NAV) of the fund over time. As an
          by the portfolio manager, while IRR captures the rate accounting quantity both determined and reported by

34                                                                                                        August 2003 • VCJ

the managers, NAV suffers by nature from valuation                                                          that there might be a difference in return. Actually, the
bias. To its big advantage, long-term IRR is a cash-on-                                                     difference comes from the net result of the investment
cash measure independent of NAV development.                                                                and divestment processes in the index-tracking fund,
                                                                                                            which either yields a positive (public market shows
                        PME Explained
                                                                                                            higher performance) or a negative balance (public
     Since IRR and TWR are different return meas-                                                           market shows lower performance). That final balance
ures and only IRR seems to be the right way to char-                                                        alone is responsible for the IRR difference. Details of
acterize the returns obtained by private equity man-                                                        computations are available in the preprint by Austin
agers, it would be helpful if some IRR could be                                                             Long and Craig Nickles (see References at the bottom
assigned to public markets to allow for comparison.                                                         of page 35).
Public Market Equivalent (PME) is an index return
                                                                                                                                          PME: The Good
measure, which is adjusted to reflect the irregular tim-
ing of cash flows actually experienced with private                                                              PME shows a very important quality: It is simple
equity. It corresponds to the dollar-weighted return                                                        and takes no more than a few minutes to understand
that would have been achieved by investing in an index                                                      how it works. It can be directly compared to the IRR
at the same time when the private equity fund makes a                                                       of the private equity fund with the corresponding cash
capital call and by selling index-shares whenever the                                                       flow pattern and, hence, conveniently provides for
fund distributes capital back to investors. This invest-                                                    apples to apples comparison. For investors not familiar
ment strategy aims to replicate the irregular invest-                                                       with IRR, the comparison can also be quantified in
ment and divestment pattern of private equity invest-                                                       terms of multiple of investment returned.
ing so as to allow for an approximate comparison of
                                                                                                                                           PME: The Bad
     Since PME is based on the same cash in- and out-              One has to be careful with the choice of a bench-
flows of the private equity fund, it seems confusing          mark index, as only total return indexes make sense for
                                                                                          the analysis. Using for
                                        FIGURE 1                                          instance the S&P 500 as a
                                                                                          benchmark while ignoring
    1,000                             Same distributions                                  dividend payments might
                                                                                          reduce PME by several
      800                                                                                 points and distort the result
                                                                                          of the comparison.
                                                                                               Despite being based on
      400                                                                                 cash flows only, PME still
                                                                          280             depends on NAV when the
      200                                                                                 fund remains not fully liqui-
                                                                                          dated and the NAV is differ-
         0                                                                                ent from zero at the end of
                                                                                          the time interval. In those
                                                                                          cases, the benchmarking
     -400                                                        Different NAV            actually reduces to the com-
                           Same drawdowns                                                 parison of the end balance of
                                                                       -6,315             the index-tracking fund to the
                                                                                          NAV of the private equity

                                                                                          fund, placing more emphasis
                                                                                           on the latter number and
Figure 1: Cash flow pattern from Thomson Venture Economics’ database for all vintage year relying indirectly on the
1985 funds (black bars) and corresponding PME based on the S&P 500 total return index assumption that the private
(gray bars) as per September 30, 2002                                                      equity investor can immedi-

VCJ • August 2003                                                                                                                                                            35

          ately exit the fund at that value. This is why PME is                       From 2000 onwards he would be making huge gains
          generally used to benchmark the performance of                              due to the 2000 to 2002 market decline. This shift
          mature funds, where the non-liquidated NAV is small                         from a long to a short position completely spoils the
          fraction of the total distributions.                                        benchmarking process and is at the origin of a low
                                                                                      PME in that case. A further direct consequence of the
                            PME: The Ugly
                                                                                      short position is that any correlation analysis based on
                As pointed out by Long and Nickles in their orig-                     PME is erroneous.
          inal work, a private equity investment
          outperforming the index is likely to                                            FIGURE 2
          yield a negative final value for the
          investment in the index-tracking fund. 12,000
          This is best illustrated with Figure 1,
          which represents the cash flows
          obtained from selecting the entire vin-       8,000
          tage 1985 of the Venture Economics            6,000
          private equity database and the cash          4,000
          flows of the corresponding S&P 500
          total return public market equivalent.
          The reported private equity NAV at                 0
          September 30, 2002, reads $280 mil-          -2,000
          lion, whereas the corresponding index-       -4,000
          tracking fund balance at the same date
          amounts to $-6,315 million, clearly
          indicating private equity out-perform-       -8,000
          ance. 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 Figure 2: Number of shares of index-tracking fund (gray shaded area), cumulative
          intuitively looks really small given the total vintage 1985 PE value (black line), cumulative total index fund value (gray line)
          performance of the S&P 500 over that
          period.                                                                        FIGURE 3
                A negative index-tracking fund       1,000
          balance means that the investor would                                        Different distributions
          have had to sell all his shares and even     800
          run a short position to match the pri-       600
          vate equity distributions. As can be
          checked on Figure 2, which shows             400
          the numbers of index shares as a func-                                                                   Same NAV
          tion of time for the PME of vintage
          1985, the number of shares is nega-             0
          tive from 1993 onwards. Over that
          period, the exposure of the investor is
          equivalent to running a short position      -400
                                                                           Same drawdowns
          in the index. Looking at the evolution
          of the cumulative total value (sum of       -600

          all distributions and current net asset
          value), it becomes obvious how the
          exceptional performance of the late Figure 3: Cash flow pattern for vintage year 1985 from Venture Economics (black
          1990s is actually working against him. bars) and PME+ with 73.5% of private equity distributions (gray bars)

36                                                                                                                                                                        August 2003 • VCJ

      Things can even get worse. Depending on the                         is showing much lower performance than the private
cash flow pattern, it might even happen that the nega-                    equity fund, it might even be necessary to use a small
tive balance at the end of the period causes the IRR to                   negative number transforming distribution into fur-
be undefined, as there is simply no discount rate which                   ther draws to make sure that the method is well
brings net present value to zero.                                         defined and yields a positive balance under all circum-
      The problem is that these situations occur not so                   stances.
infrequently. More than one out of five of the private                           The optimal proportion is obtained by scaling
equity funds that we benchmarked utilizing this                           down distributions until the end balance matches the
methodology generated short index exposure through                        final private equity NAV. Such a choice is not arbitrary,
the life of the investments. Only a few funds yielded                     as it ensures a similar level of exposure in the future.
PME cash flow patterns with undefined IRR.                                This is best illustrated in Figure 3, where all divest-
                                                       +                  ments from the index-tracking fund have been re-
              Understanding PME
                                                                          scaled to 73.5% of vintage 1985 distributions. The
      The beauty of PME lies in the simplicity of the process yields a cash flow pattern similar to the private
assumptions and the transparency of the method. Any equity one, with an end balance matching private
amendment should aim to preserve these two charac- equity NAV. The corresponding public market IRR
teristics, while avoiding the unpleasant issue with the amounts to 14.4% and is this time truly representative
short exposure.                                                           of the performance of long U.S. public equity markets
      A very simple way of preventing negative balances for that period.
—at least at the end of the period—is to redeem a con-                           Figure 4 shows the running number of index
stant proportion of the distributions instead of the full tracking fund shares, which remains positive over the
amount. Using a fixed proportion over time ensures entire period. As a result, one can verify that the
that the overall cash flow pattern is preserved. The cumulative total value for both public and private
smaller the scaling factor, the longer the money is stay- equity showed positive returns from 1993 to 2000, and
ing in the fund and the longer the balance is going to flat or negative returns from 2000 onwards, as one
stay positive. In extreme cases when the public market would have expected for those markets.
                                                                                                          Since the amended
                                               FIGURE 4                                              PME computation that we
                                                                                                     have introduced here aims to
    12,000                                                                                           preserve the long (or posi-
                                                                                                     tive) exposure to the bench-
    10,000                                                                                           mark 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
     6,000                                                                                           positive end balance, it does
                                                                                                     not guarantee that the expo-
     4,000                                                                                           sure stays positive over the
                                                                                                     entire investment period.
                                                                                                     Only one of the private
                                                                                                     equity funds that we have
                                                                                                     benchmarked with PME+ so
           0                                                                                         far has shown a few quarters

                                                                                                     with negative exposure,
                                                                                                     whereas IRR was always well
Figure 4: Number of shares of index-tracking fund for PME+ (gray shaded area), cumulative total pri- defined for all PME cash
vate equity value (black line) and cumulative total index fund value (gray line)                     flow patterns.

VCJ • August 2003                                                                                                                                     37

                                                                      FIGURE 5                  strongly negative for vin-
                                                                                                tage 1982. It is important to
                                                                                                note that this premium
                                                                                                stands for the overall pri-
                                                                                                vate equity yield pick-up,
         10%                                                                                    independent from the man-
                                                                                                ager, who plays an impor-
          0%                                                                                    tant role in the generation
                                                                                                of higher returns for alter-
        -10%                                                                                    native asset classes.
                                                                                                     The PME+ tool pro-
                                                                                                vides a reliable framework
                                                                                                for the comparison of pri-
                                                                                                vate equity returns with
                                                                                                returns of other asset
                                                                                                classes. The major objec-
Figure 5: Comparison of private equity IRR (black bars) and S&P 500 total return PME+ (gray tion to the approach,
bars) by vintage year. Private equity is represented by the pooled cash flows from a given vin- namely that the cash flow
tage year in Venture Economics’ database.                                                       patterns are not exactly
                                                                                                matching, is mitigated by
              Does Private Equity                                                               the fact that at least tim-
        Outperform Public Equity?                                 ing, in-flows and a fixed proportion of out-flows are
                                                                  the same, which seems to be the minimum that can
      The same analysis for the S&P 500 total return be relaxed to fix the benchmark. The results pre-
index and the pooled data corresponding to the entire sented in the last section are shown for illustrative
private equity market from 1980 to 2000 yields 14.4% purposes and could easily be refined to better char-
IRR for private equity and 9.2% for PME+, indicating acterize the performance of venture capital, buyout
an overall 5% premium for illiquidity. The choice of the and mezzanine funds with respect to specific indexes,
S&P 500 total return is motivated here by its wide or to estimate the excess yield obtained with top
acceptance as a benchmark for the performance of U.S. quartile managers.
public equity markets, as opposed to its relevance to
the private equity market.                                        Christophe Rouvinez is a partner in Capital Dynamics,
      Figure 5 gives a breakdown of the results by vin- an asset management firm that specializes in private
tage year, which clearly shows that this premium fluc- equity. Capital Dynamics has offices in Zug, Switzer-
tuates widely over time, and even turned out to be land 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
 ª VentureXpert, Cash Flow Reports as per 09/30/2002

38                                                                                                                                                               August 2003 • VCJ

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