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Which index should you use for a private equity PME?

One set of fund cash flows run against four plausible benchmarks, to show how much of a PME is the fund and how much is the choice of index.

Julian R. Sterling · from Private Markets Performance

Use a total return index that matches the fund's market, the size of company it buys and the investor's reporting currency, and fix it before the result is known. The choice is not cosmetic: on one illustrative euro buyout fund with an 11.73 per cent IRR, the Kaplan-Schoar PME is 1.396 against a European large-cap total return index, but anywhere from 1.231 to 1.574 against three other indices an analyst might pick, one of which should never be used.

Worked in full in Private Markets Performance by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →

A public market equivalent asks what the fund's own cash flows would have earned in a listed index on the same dates. The fund's side of that comparison is fixed. The index side is a choice, and most of the argument over whether a manager "beat the market" is really an argument over which market. The way to settle it is to run the same flows against each candidate and see what the choice is worth.

The fund and the candidate indices

Illustrative euro buyout fund per 100 committed, and annual index total returns in euros (global series shown rounded to whole per cent).

Year	Fund net cash flow	European large cap	European small cap	Global, in euros
0	−20
1	−25	12%	20%	15%
2	−20	8%	10%	10%
3	−15	−4%	−8%	−5%
4	−10	18%	25%	23%
5	15	10%	14%	10%
6	25	−12%	−16%	−8%
7	30	15%	20%	17%
8	35	9%	10%	10%
9	30	6%	7%	9%
10	NAV 45	7%	8%	9%
Compound annual return	IRR 11.73%	6.55%	8.29%	8.77%

The fund called 90, distributed 135 and holds a NAV of 45 at year 10: TVPI 2.00x, DPI 1.50x. The fourth candidate is the price version of the large-cap index, which is the total return less an illustrative 2 per cent dividend yield each year: 4.54 per cent compound.

Step 1: the PME against the reference index

The full method is set out in how to calculate the Kaplan-Schoar PME. Here the interest is only in what happens when the index column changes and nothing else does.

Step 2: the same flows against each candidate

One fund, four indices. Change measured against the European large-cap total return index.

Index	FV of distributions + NAV	FV of calls	KS PME	Change	Direct Alpha
European large cap, total return	208.20	149.11	1.396		5.52%
European large cap, price only	199.81	126.96	1.574	+12.7%	7.57%
European small cap, total return	213.34	166.13	1.284	−8.0%	4.10%
Global, total return in euros	218.60	177.51	1.231	−11.8%	3.42%

Every row says the fund beat the listed market, but by how much ranges from 3.42 to 7.57 per cent a year of Direct Alpha. A gap of 4.14 points a year comes from the benchmark alone, with the fund's cash flows unchanged. The index is not a detail of the PME; it is half of it.

What each choice does

• Price instead of total return. The price index omits the dividends a listed investor would have received, so the benchmark compounds 2 points a year too slowly. The PME rises by 0.178 for nothing the manager did. This is never a defensible choice: the fund's distributions include its companies' income, and the index must too.
• Small cap instead of large cap. Buyout funds own companies whose size, leverage and sector mix sit closer to small and mid caps. In this illustrative decade small caps compounded 1.74 points a year faster, and the PME falls by 0.112. In a decade led by the largest companies the sign reverses, which is why the choice must be made on the fund's strategy, not on the result.
• Global instead of regional. A global index converted into euros returned 8.77 per cent a year here, against 6.55 for the European one. Against it the euro fund's PME is 1.231. That is the right test for an investor whose alternative really was a global equity allocation; it is the wrong one for judging a manager hired for European mid-market buyouts.

Two questions settle most disputes. What would this investor have bought with the money instead? And what market does the manager actually invest in? When they give different answers, report both PMEs and say which question each one answers.

The common mistakes

• Choosing after the fact. Picking the index that flatters the fund is the commonest abuse of PME. Write the benchmark into the reporting policy before the vintage is measured, and keep it.
• Mixing currencies. The fund's flows and the index must be in the investor's reporting currency. A euro fund against an index left in another currency is a currency bet disguised as a benchmark.
• Ignoring leverage. Even the right index carries less debt than a buyout company. That is a separate adjustment, covered in how to adjust a PME for private equity's leverage, and it should be layered on the right index, not used to rescue the wrong one.

Takeaway

The same cash flows produce a PME of 1.231, 1.284, 1.396 or 1.574 depending only on the benchmark. Use total return, match the market, size and currency, decide before you look, and show the alternatives where reasonable people would choose differently. Private Markets Performance runs all four public market equivalent methods on one fund, and the free workbook for this case includes a PME calculator into which you can paste any index series to repeat this test on your own fund.

Questions readers ask

Should a PME use a price index or a total return index?

Always total return. A fund's distributions include the income its companies earned, so the index must include dividends too. On the illustrative fund, swapping a total return index for its price version, 2 points a year lower, lifts the Kaplan-Schoar PME from 1.396 to 1.574, 12.7 per cent better for nothing the manager did, and Direct Alpha from 5.52 to 7.57 per cent.

Is a small-cap index a better PME benchmark for buyout funds?

Often, because buyout funds own companies closer in size to small and mid caps than to the largest listed groups. It is not automatically tougher: it depends on the period. Here the small-cap index compounded at 8.29 per cent against 6.55 for large caps, and the fund's PME fell from 1.396 to 1.284. In a decade when large caps led, the order reverses.

Does the currency of the index matter for a PME?

Yes. Cash flows and index must be in the same currency, the one the investor reports in. A global index converted into euros returned 8.77 per cent a year here against 6.55 for the European index, and cut the PME of a euro fund from 1.396 to 1.231. Mixing a euro fund with an index left in another currency builds a currency bet into the benchmark.

Also on this site

• How do you calculate the Kaplan-Schoar PME?Grow distributions, NAV and calls at the index total return, then divide. An illustrative fund with a 12.09% IRR returns 191.57 for 156.18: a PME of 1.227.
• How do you calculate Direct Alpha for a private equity fund?Compound each cash flow to the end date at the index total return, then take the IRR. An illustrative fund earns 4.83% a year of Direct Alpha, not 4.61 points.
• How do you adjust a PME for private equity's leverage?Lever the index first: beta 1.15 funded at 2 per cent lifts it from 7.1312 to 7.8203 per cent a year and cuts the PME from 1.2554 to 1.2255.
• How do you benchmark private equity against an index plus 3%?Run a PME on the index grown at index plus 3 per cent, not the IRR against a CAGR. A fund that misses by 0.08 points on the CAGR beats it with a PME of 1.040.
• How does a lagged NAV distort a private equity PME?Pairing a September NAV with a December index flatters the PME after a falling quarter: an 8 per cent fall turns a young fund's 1.107 into 1.203.
• How do exchange rates change a private equity fund's IRR?Convert each flow at its own date's rate: a euro fund earning 14.57% returns 12.71% to a dollar investor after a 10% fall in the euro, not the 13.07% shortcut.

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