Several research groups and academic experts measure the returns of the private equity asset class to assess its relative return performance and investment merits. This research, which is gathered from the general and limited partners who run and invest in such funds, provides important market based data to assist institutional investors in determining several factors. These determinations include the correlation of such returns to other asset classes in their portfolios, how much relative capital to allocate in the portfolio, and which specific funds might make sense to invest in. One of the metrics used to analyze these dynamics is known as the Public Market Equivalent (PME) ratio, which measures the return on private equity investments net of fees to the return of indices in the public markets.
The PME approach is calculated as a dollar weighted return that would have been achieved by replicating the fund’s cash flow with a market index. Whenever the fund makes a capital call, the same amount is invested in an index. If the fund disperses cash, an identical amount of index shares is sold from the index portfolio to arrive at the same cash flow pattern. However, this procedure often leads to situations where the benchmark is nonsensical or simply does not exist. When using this measure for all cases where the private equity firm outperforms the benchmark, the benchmark will eventually turn negative values (that is, the public market must be shorted). A comparison between a long private equity position and a short position in the public equity index does not make sense.
One proposed solution for this issue is to avoid the problem of short positions altogether by selling a fixed portion of the positive cash flows (as opposed to the exact same amount with standard PME). The fund with the better performance relative to such an index has the higher PME. According to one research firm that is widely acknowledged as having the most robust data (Burgiss), PMEs for the private equity class for the vintage years between 1984 and 1996 have been volatile, but positive (ranging from approximately 0.8 to 2.4x). These years are especially relevant as they encompass the average lifecycle of a private equity fund from initial investment through realizations, and excluding any return data derived from subjective mark-to-market data inherent in the reporting of unrealized returns.
These findings could serve as important and relevant market based evidence of control and liquidity discounts when assessing the value of interests of private companies and, possibly, holding companies that own private equity interests. More specifically, the incremental return generated by private equity investments indicates the incremental return limited partner investors require to compensate for their illiquidity and lack of control. It is also important to note that the private equity firms mitigate some liquidity risk vis-à-vis periodic distributions harvested from the realization of specific investments (suggesting they may have slightly lower premiums than if the funds had no distributions between the aggregate capital investment and a final realization at a terminal date). In utilizing this date for a composite discount, the inverse of the ratio could serve as another data point for a conjunctive discount, inclusive of both control and liquidity. When coupled with the market based observations of price to NAV ratios of private equity LP interests traded on secondary markets (discussed in an earlier post), these two data sets could offer a very compelling set of empirical discount information accessible by valuation professionals in exercises that involve the valuation of non-controlling, non marketable interests in privately held companies.
1. “Encyclopedia of Alternative Investments” edited by Greg N. Gregoriou