1

Measuring private equity returns

and benchmarking against public
markets


Colin Ellis, University of Birmingham, c.ellis@bham.ac.uk
Sonal Pattni, BVCA, spattni@bvca.co.uk
Devash Tailor, BVCA, dtailor@bvca.co.uk



Executive summary

Private equity is still a relatively young asset class, with some unique characteristics. One feature is the
very irregular timing of cashflows, and a consequence of this is that private equity relies on measures
of returns that are not standard in other asset classes. As such, new investors can be unclear or
unaware of the differences between the common methods for measuring private equity performance
and comparing it with returns from other asset classes. This paper sets out different methods for
measuring private equity returns that are commonly used in the industry and constructs aggregate
indices for the UK asset class. It also considers methods for comparing private and public equity
returns and demonstrates the importance of considering cross-sectional variation between public and
private equities.

Keywords: private equity; performance measurement; aggregation; public market comparison







Acknowledgements
We are very grateful to Mark Drugan of Capital Dynamics, members of the BVCAs Research Advisory Committee, and BVCA
colleagues for their comments and advice. All remaining errors are our own. The views expressed in this paper are those of the
authors and do not necessarily reflect those of the BVCA.
2



Contents
Page no.

1. Introduction

2. Methodological discussion
2.1 Key PE multiples
2.2 Advantages and drawbacks of multiples
2.3 The internal rate of return (IRR)
2.4 Advantages and drawbacks of IRRs
2.5 Modified IRR (MIRR) and isolated MIRR
2.6 Aggregation issues
2.7 Constructing PE indices

3. Making comparisons with public markets
3.1 The Public Market Equivalent (PME) method
3.2 Short positions and PME+
3.3 Choosing the appropriate public index
3.4 Correlation analysis: time series vs. cross section

4. Summary & conclusions

References




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3

1. Introduction


A key concern for financial investors is deciding how to allocate their assets, or where to put their
money. Central to this is the risk-reward trade-off that is offered by different asset classes. For
mainstream financial assets, such as bonds or equities, measures of returns are relatively simple to
construct and well-understood. The current or historical yield (and sometimes the expected yield) is
fairly easy to calculate, although the ex-ante risk of default can be less clear. Where possible, risk-
adjusted measures of returns are often used. But gauging the financial performance of private equity
(PE)
1
funds is more difficult.

Unlike bonds and equities, which have defined markets and good liquidity to enable investors to buy
and sell assets, commitments to PE funds are typically held for long periods of time. Furthermore, the
time profiles of the investments are very different. For bonds and equities, investors invest money at
the point of purchase, receive regular dividends or coupons, and receive final proceeds at the point of
sale. Depending on whether market prices have risen or fallen over time, the sale price could be higher
or lower than the initial purchase price. Cashflows for private equity are rather more irregular. For
instance, once an investor has made a commitment to a fund it may not be called upon for many
months or years, but then will be called upon many times over the life of the fund at unpredictable
intervals. This irregular timing of cashflows between PE funds and their investors is one of the
defining characteristics of the asset class.

In light of these distinctions, measuring PE returns requires a different approach to measuring the
performance of more traditional asset classes. There are two widespread measures in the industry,
namely money or cash multiples and the so-called internal rate of return. Both measures have
advantages and disadvantages, and have sometimes been criticised as unrepresentative of real
returns. In addition, the comparison of PE returns with public markets can be fraught with difficulty.

This paper contributes to this debate, first by describing and explaining the different measures of PE
returns, and then examining the different weighting and aggregation approaches that are used to
produce industry-wide estimates of returns. We also construct indices of UK PE returns using data
from the BVCAs Performance Measurement Survey (PMS). Finally, we examine the nature of cross-
correlations between PE funds and public equity markets, highlighting some potential concerns with
an aggregated time-series approach.





1
Throughout this paper, we use private equity to refer to the whole universe of private equity investments, notably including
both venture capital and buyout investments.
4

2. Methodological discussion


When measuring PE returns, investors must consider a number of issues that also affect other asset
classes. These include whether to look at gross or net performance (i.e. once fees, and in the case of PE
carried interest, are subtracted), and comparisons with the alternatives that are on offer. However, in
the case of PE, due to the irregularity of cashflows the standard time-bound return measures are
inappropriate. In its simplest form, the buy-and-hold return on a zero-coupon bond would be given
by:



In the case of coupon-yielding securities, or dividend paying equities, the calculation becomes a little
more complex. Coupons and dividends are typically assumed to be re-invested into the fixed-income
security or equity at the prevailing market price when they are paid. However, the basic structure of
the return calculation final cash returned as the numerator and initial investment as the
denominator broadly remains the same.

Private equity, however, is somewhat different. Due to the irregularity of PE cashflows, and the lack of
a genuine re-investment option, this sort of return calculation is not appropriate for the asset class.
Instead there are currently two widely accepted approaches for calculating PE returns. The first is to
present so-called multiples, and the second is the internal rate of return (IRR). We will consider each
in turn.
2



2.1 Key PE multiples

Simply put, multiples are typically calculated as the ratio of cash paid out (also known as
distributions) to total funds that the investors supplied to the PE fund manager (also known as draw
downs or capital calls). The main disadvantage of this approach is that it does not consider the timing
of those cashflows. Depending on the precise multiple used, unrealised returns may also be included
in the calculation. There are three key measures of multiples.
3


Distributions to Paid In (DPI) capital





2
Talmor and Vasvari (2011) offers a good guide to performance measurement, and indeed private equity more generally.
3
Another ratio, of Paid In to Committee Capital (PICC), measures the proportion of money that has been drawn down from all
the funds that investors have committed. However, it does not measure returns.
5

The DPI simply tells us what proportion of money that has been drawn down by GPs has so far been
paid back. If this figure were one, then investors would have so far received back exactly the same
amount that they had initially paid. Typically, over the life of a PE fund, the DPI will start at zero, and
gradually rise as the fund matures.

As such, the DPI is not a good measure of returns in two situations. The first is where the fund is not
yet at the end of its life as, by definition, this measure of returns excludes all unrealised returns (i.e.
the value of equity stakes and other instruments in unsold companies). The second is where a fund
has yet to invest all of its capital, which can result in an interim DPI that may be unusually volatile as
early investments potentially exit and/or new money is drawn down. Real returns will even be
negative in the short term, as fees are drawn before investments are made.

Residual Value to Paid In (RVPI) capital



The RVPI measures how much of a funds return is unrealised, relative to the money that investors
have paid in. This unrealised or residual value often referred to as a net asset valuation is
subjective and may be calculated using a variety of methods. However, previous research suggests that
there is little sign of systematic bias in valuations, at least for relatively mature funds (Ellis and Steer,
2011). The RVPI measure excludes any previous distributions the PE fund may have made, so again
represents an incomplete picture of returns.

Total Value to Paid In (TVPI) capital



The TVPI gives the overall (but potentially unrealised) performance of a PE fund. It tells us what
multiple of the investment would be returned to investors if the unrealised assets were sold at current
valuations and added to distributions that had already been received. The TVPI is the best overall
multiple measure of returns, although there will obviously be uncertainty about the final outcome for
as-yet unrealised investments.

Simple algebra shows the relationship between these three measures:





6

2.2 Advantages and drawbacks of multiples

The key advantage of multiples as a measure of PE returns is that they are very simple to understand.
Multiples are frequently used by PE funds to give investors an indication of how individual
investments have performed for instance, a 1.5x result tells investors that they have received a 50%
return on their investment.

However, multiples also suffer from clear drawbacks. The most obvious of these is that they do not
consider the timing of draw downs or distributions within the investment process, and hence
implicitly do not consider the time value of money. A multiple of 1.5x delivered over a ten year period
is not an especially strong performance, in terms of the implied geometric annual return. This
suggests that, when multiples are used as a measure of PE performance, investors should also be told
the duration of the investment.

Concerns have also been raised that multiples do not provide investors with information about the
underlying risk of the investments, or the potential reinvestment performance of distributions.
However, this critique also applies to measures of returns in some other (more traditional) asset
classes. When a listed company pays out dividends it provides little information about the covariance
of its share price with other equities, or advice on the return shareholders can expect from investing
that dividend elsewhere. For the purposes of this paper, we focus on the elements of return
measurement that are unique to private equity.


2.3 The internal rate of return (IRR)

The second common measure of PE returns is the IRR. Technically this is the discount rate that
ensures that the net present value (NPV) of a series of (positive and negative) cashflows is equal to
zero. In economic terms it is best represented as the denominator-based element of the nonlinear
calculation:

where NPV denotes net present value, Ci denotes cashflow in period i, and r is the calculated internal
rate of return.

In practice PE funds are typically long-lived, and interim estimates of returns must be based on
implicit assessments of expected future cashflows. This is measured by the net asset value (or NAV)
of the fund. In these instances the IRR calculation at period i becomes:
4

4
Technically, the discount rate applies to the final NAV as well. For simplicity, this has been subsumed in both this and the
subsequent equation.
7

Ellis and Steer (2011) describe NAVs and their role in interim measures of IRR in more detail, and
investigate their accuracy. Once funds are sufficiently mature typically, around four to six years after
the first draw down they find no evidence of systematic over- or under-valuation across a sample of
closed UK funds.

The equation set out above can be applied both in a forward-looking and backward-looking context.
The best IRR estimate of returns is the so-called since inception measure, where all cashflows in the
fund (or deal) and the latest valuation are used in the calculation.
5
However, backward-looking
measures of returns can also be prevalent. These are often referred to as ten year or three year
returns, depending on the length of time over which the return is calculated. Backward-looking return
measures are calculated by liquidating the residual fund value at the start of the time period (and
treating it as a negative cashflow), and then considering cashflows and the final NAV over the
remaining life of the fund. Technically, for a five year backward-looking IRR, this implies that the IRR
is calculated as:

2.4 Advantages and drawbacks of IRRs

The main advantage of an IRR is that it provides a percentage-based metric for returns that explicitly
takes the irregular timings of PE cashflows into account. An IRR is normally measured as a per annum
percentage (% p.a.).

However, the main disadvantage of an IRR is that it is more complex than it can first appear, with a
number of resulting issues that investors may not always be aware of. The IRR is a non-linear
denominator-based measure of returns. It is not a standard time-bound numerator-based return,
unlike most buy-and-hold estimates of returns. Nor is it directly comparable with these standard
measures of returns. When we compare PE with other asset classes, the IRR cannot simply be lined up
next t0 the buy-and-hold return from a fixed income fund, for example.

The non-linear nature of the IRR is the source of much misunderstanding. Figure 1 illustrates this
non-linearity, plotting the implied discount rate that would ensue from the sorts of standard models
of consumption behaviour, where the discount rate is normally expressed as a numerator-based
measure:





5
Technically, this implies that the summation of discounted cashflows starts in period 0 (i=0).
8

Figure 1: Relationship between numerator and denominator-based discount rates


The non-linear nature of the IRR means that IRR algorithms can sometimes fail to solve it is more
computationally complex than a multiple.
6
The non-linearity can also cause potential confusion for
example, if a fund closes after five years but is assumed to have lived for an extra five years without
doing anything, the five and ten-year IRRs will be identical. This is because there are no extra
cashflows to discount between years six and ten (although any fees drawn during that time would
lower the IRR).

This also applies when returns from funds with different durations are considered. Table 1 presents an
example using illustrative data. Fund A in the table is only active for four years so its IRR really
corresponds to the return over that four year period. Fund B, by contrast, is active for seven years, and
its IRR corresponds to that duration. However, the raw IRR data themselves do not indicate this
timing difference. Furthermore, if the IRR calculation for Fund A was calculated up to Year 7, then the
addition of three extra years would have no impact on the calculated IRR as the numerator for all
three years would be zero.




6
However, this algorithm is present or can easily be constructed in most major software packages. The appropriate function in
Excel is XIRR.
0.98
1.00
1.02
1.04
1.06
1.08
1.10
1.12
1.14
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0.40
0.45
0.7 0.75 0.8 0.85 0.9 0.95 1
Numerator-based discount rate ()
Implied IRR (LHS)
Sum of and IRR (RHS)
9

Table 1: Hypothetical PE fund cashflows
Fund A Fund B
Year 1 -1000 -1000
Year 2 1300 0
Year 3 500 0
Year 4 0 0
Year 5 0 800
Year 6 0 0
Year 7 0 500
IRR 61% 6%


This example demonstrates a related issue with IRRs: early distribution of cashflows and early
termination of a fund can boost measured returns, as IRRs can implicitly put very high weight on
short-term returns. This follows from the geometric discount rate that the IRR formula implies and is
illustrated in Figure 2. Under high IRRs, future cashflows are discounted very quickly and hence have
relatively little implicit weight in the underlying calculation.


Figure 2: Impact of IRRs on discounted cashflows (a)

(a) This chart shows the present discounted cashflow of 100 at a future date, under the IRRs that are assumed for illustrative
purposes. For instance, with an IRR of 20%, 100 in four years time is only worth 48 today.


This means that PE fund managers face incentives to deliver cash more quickly to shareholders. Some
commentators have suggested that fund managers may choose to manipulate the timing of returns to
their advantage, for instance by distributing cashflows near the end of a funds life when it may have
little impact on the measured IRR. For instance, if Fund A in Table 1 distributes another 100mn in
0
20
40
60
80
100
120
0 1 2 3 4 5 6 7 8 9 10 11 12 13
5% IRR
10% IRR
20% IRR
30% IRR
Present value of 100
Number of years in the future
10

Year 8, the measured IRR will still be 61%. However, any change in the timing of distributions can
potentially also have a knock-on impact to the performance-related proceeds that fund managers can
enjoy.
7


As these timing issues already hint, a full and accurate picture of returns is only presented by the
since-inception IRR. While backward-looking measures of returns can provide some guide to the
recent performance of funds, by definition they will not cover some areas of a funds life. And given
the irregular nature of PE cashflows, and the non-linear return algorithm, this means that backward-
looking IRRs can also be very volatile and potentially misleading. Figure 3 plots three, five and ten-
year returns for a genuine fund in the BVCAs Performance Measurement Survey (PMS), along with
the since-inception return as it evolved over time. Anyone expecting substantial returns on the basis of
the 66% five-year estimate would clearly have been disappointed. In contrast, since-inception IRRs
paint a more accurate picture of true returns.


Figure 3: An example of since-inception and backward-looking returns



2.5 Modified IRR (MIRR) and IMIRR

In response to these concerns about IRRs, alternative measures of returns have been proposed. The
most noteworthy of these is the Modified Internal Rate of Return, or MIRR.

In truth, the so-called MIRR is fundamentally different from the IRR (and is not really an internal rate
of return at all, in economic terms). The IRR is named for its use in discounting internal cashflows,
and is a denominator-based measure of returns. In contrast the MIRR is a numerator-based measure

7
Ellis (2011) describes the typical form of incentive structure for these performance-related proceeds, often referred to as
carried interest. As carried interest is only payable once the preferred return (or hurdle rate) has been reached, which is
annually compounded, fund managers are incentivised to exit swiftly.
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
70%
80%
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Since-inception return
Year
Ten-year return
Five-year return
Three-year return
11

of returns that is more akin to a standard buy-and-hold measure of returns.
8
Broadly speaking, the
MIRR is calculated as:

Importantly, the MIRR assumes that investors earn money on their capital (at an interest rate known
as the saving rate) before it is drawn down by PE fund managers, and that after distributions are
returned to investors they are able to earn further money on those funds (the investment rate). As
such, the MIRR is essentially akin to a conventional numerator-based measure of returns such as the
FTSE All-Share Total Return index, which takes account of dividends paid by its constituent members.

As an example, consider Table 2, which is taken from Phalippou (2008). The investor commits 100
in Year 0, and then receives 150 in Year 1, and 50 in Year 3. The assumed reinvestment rate for the
investor is 12% per annum.
9
In order to calculate the MIRR, it is necessary to accumulate the post-PE
investment returns each year. Column A shows the post-PE investment return earned each year and
column B shows the cumulative fund value.


Table 2: Calculating a MIRR (a)
Timing PE cashflow
Investment
return (A)
Cumulative
return (B)
Year 0 -100 0 0
Year 1 150 0 150
Year 2 0 18 168
Year 3 50 20.2 238.2
Year 4 0 28.6 266.7
Year 5 0 32.0 298.7
Year 6 0 35.8 334.6
Year 7 0 40.2 374.7
Year 8 0 45.0 419.7
Year 9 0 50.4 470.1
Year 10 0 56.4 526.5
Year 11 0 63.2 589.7
Year 12 0 70.8 660.4
(a) Numbers have been rounded to one decimal place.


8
Confusion about this distinction often surfaces with claims about the so-called reinvestment rate, which flip between
numerator and denominator-based measures of returns. Simply put, the IRR and MIRR are not comparable because they are
fundamentally two different measures of returns.
9
Arguably, this seems high. But our focus here is on replicating the results in Phalippou (2008), where this assumption is made.
In practice, it would be possible to construct a MIRR, using total return indices for either public equities or gilts (these are
discussed in Section 3.3). One issue here would be the possibility of investors going short when large draw downs were made, in
the event that market prices had moved against them.
12

In order to calculate the reported MIRR of 17% in Phalippou (2008), the final cumulative return of
660.4 is compared with the original 100 investment and geometrically discounted:

/


Given that non-linear algorithms already exist for the calculation of IRRs, the MIRR is at least as
computationally intensive.

There are, however, more fundamental concerns about the MIRR. First and foremost, it is arguably
not genuine a measure of PE returns, most obviously because the saving and investment rates that
investors earn are beyond the control of PE fund managers. Investors in private equity generally
accept this point. The MIRR formula is essentially similar to that of a multiple, albeit with a time
superscript added, and the added complication of the saving and reinvestment rates.

One other obvious drawback of this MIRR, as reported in Phalippou (2008), is that it assumes the PE
fund continues long after the final distribution (i.e. after Year 3 in Table 2). This means that the final
return estimate is biased towards the investment rate which is assumed in the calculation (in this case
12%). The author addresses this by proposing a modified form of the MIRR known as the isolated
MIRR or IMIRR. This measure of returns is only calculated over the active life of the fund (in this
case, up to Year 3):

/


Phalippou (2008) recommends using the IMIRR for individual funds but the MIRR for aggregated
estimates of returns across several funds. Aggregation is an important issue for PE returns more
generally; the next section examines this in more detail, and highlights some issues with this
aggregate MIRRs.


2.6 Aggregation issues

Thus far, the discussion has implicitly assumed that returns are being calculated for individual
investments or funds. However, in practice, industry-wide measures of returns are also of interest, not
least for benchmarking purposes.
10
In order to do this, there needs to be some method of combining
returns data across different funds.

In other fields, the simplest approach would be to weight different fund returns together in a standard
fashion:

10
For a good discussion of benchmarking and concerns with commercial datasets, see Harris et al (2011).
13

where denotes the weight attached to each fund. However, deciding upon appropriate weights is
non-trivial. In principle, options include fund commitments, total draw downs, or plausibly the
maximum of these two measures (as some funds ask for extra funds beyond initial commitments). But
the different timing and duration of different funds should ideally also be taken into account a fund
delivering returns over five years should be treated differently to an identically sized fund delivering
returns over ten years.

In light of these sorts of weighting issues, a common approach when calculating aggregate measures of
returns is to pool the data across funds. This approach assumes that the different cashflows and
valuations come from a single entity rather than multiple PE managers. This means that cashflows
from all funds are treated as if they were part of one large fund, and valuations are summed to get
aggregate NAV figures. This simple approach is frequently used, but implicitly ignores growth and
inflation effects,
11
meaning that in truth aggregate return estimates will be biased towards later funds.

While pooling is a simple way of aggregating across different sized funds, care is required when
interpreting the results. Table 3 presents three hypothetical funds with different cashflows but the
same starting draw down period.

Table 3: Pooling hypothetical fund returns
Fund A Fund B Fund C
Dates Cashflows Dates Cashflows Dates Cashflows
31/12/2005 -1000 31/12/2005 -1000 31/12/2005 -1000
31/12/2006 1300 31/12/2006 0 31/12/2006 0
31/12/2007 500 31/12/2007 0 31/12/2007 0
31/12/2008 0 31/12/2008 0 31/12/2008 0
31/12/2009 0 31/12/2009 500 31/12/2009 800
31/12/2010 0 31/12/2010 0 31/12/2010 600
31/12/2011 0 31/12/2011 600 31/12/2011 0
IRR 61%

2%

8%


On an individual fund basis, the IRR of fund A is 61%, Fund B is 2%, and Fund C is 8%. If the
cashflows from these three funds are pooled together the aggregate IRR is 12%, compared with the
average individual fund IRR of 24%. The lower pooled IRR reflects the fact that the distributions for
Funds B and C are delayed relative to Fund A. However, the effect would have been reversed with two
early-paying (and high IRR) funds and one later fund. Notwithstanding the aggregation issues that are
present with a weighting approach, care must therefore be taken with pooled IRRs.
12



11
As national income and wealth typically grow over time, it may not be appropriate to weight different funds together solely on
the basis of nominal fund sizes. In economic terms, a 100mn fund established in 1980 is not equivalent to a 100mn fund
from 2005. One way to adjust these nominal weights would be to take account of inflation, using either a consumer-based or
whole-economy measure. But that will fail to take account of economic growth: this means that, even if private equitys
proportional allocation within overall investments were constant, fund sizes would still increase over time. As such it could
arguably be appropriate to adjust fund sizes by nominal GDP, rather than just inflation.
12
Concerns also arise when constructing pooled MIRRs; typically, given the growth in the PE industry over time, these will by
construction be biased towards the assumed saving rate.
14

2.7 Constructing PE indices

The rationale for constructing an aggregate measure of PE returns is to summarise how a large group
of PE funds perform. An obvious extension of this approach is to construct a PE index a measure of
how the industry as a whole has delivered returns over a long period of time.

The BVCA is well placed to lead this effort given the long pedigree of its Performance Measurement
Survey (PMS). Every year the BVCA collects raw cashflow and valuation data from its members, in
order to provide investors with good benchmarks of PE returns. Data are only collected from non-
captive members and is reported on a net-of-fees basis, in order to reflect the type of return that
investors can genuinely expect. The 2010 report compiled data from over 450 UK-managed funds and
as such is the most comprehensive source of UK PE returns.
13


Constructing a PE index is complex using IRR methodology; by its very nature indexation tends to
lend itself more naturally to a multiples-based approach. The Thomson Reuters/EVCA PE index pools
cashflows across funds and calculates the resulting changes in value on a cashflow-neutral basis. The
change in the PE index (PEI) between period i and period j is calculated as:

These changes are usually calculated over fixed periods of duration, and then chained together to form
an index. In the case of the PMS the net valuations are provided once a year, so the appropriate
duration is one year. Using BVCA data, this yields the PE index shown in Figure 4 below: over the
sample shown, the average annual growth rate is 11.4%.




13
The PMS is described more fully in BVCA (2011).
15

Figure 4: A representative UK PE index (a)

(a) Calculated using all BVCA fund data.


Some investors may require higher frequency data than this annual series provides. There are several
possible options in response, including constructing quasi-NAVs using observed cashflows to generate
higher-frequency valuation measures. These can then be used to calculate index changes over sub-
periods. In practice, however, this approach is not very different from a simple interpolation process,
especially when aggregating across a large number of funds.
14
One alternative would be to interpolate
between the annual observations using some other indicator variable, following the procedure set out
by Chow and Lin (1971). Figure 5 presents results for this approach, using the LPX50
15
as the indicator
variable. This series is highly volatile, and so the resulting return estimates are more variable than
simple quadratic interpolation alone would suggest. Even restricting changes to an annual frequency,
the LPX50 appears to be far more volatile than standard measures of PE returns: the variance of
annual growth rates is almost 12 times that of the PE index we constructed (Figure 4).



14
Discussions with fund managers have indicated that, aside from large draw downs or distributions, NAVs typically do not
change much over a three-month period.
15
The LPX50 is an index of the 50 largest listed private equity companies, which meet certain liquidity constraints. For more
detail see: www.lpx-group.com.
-15
-10
-5
0
5
10
15
20
25
30
35
0
200
400
600
800
1000
1200
1400
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
Index, 1994=100
Per cent
PMS index (LHS)
Annual change (RHS)
16

Figure 5: Interpolated PE returns



A final option for constructing a PE index would be to properly take account of the growing market
over the past 20 years, and construct a genuinely chain-linked measure of returns.
16
In the presence of
changing market or fund sizes, simple aggregation methods can result in misleading growth rates over
time, which chain-linking can resolve. In technical terms, this approach requires annual updating of
the individual fund weights; the return on each fund within each year is calculated, and these growth
rates are then weighted together using the sizes of live funds as the weights.
17
In this way we can
accurately capture the returns that are on offer from active funds. However, in practice this approach
is also unrealistic: it implicitly assumes that investors liquidate their PE holdings at the end of each
year and then re-invest in all live funds one day later at prevailing NAVs. As such, there is a trade-off
between the beneficial statistical properties of a genuinely chain-weighted index and investors ability
to mimic it in practice.



16
See Whelan (2000) for a discussion of chain-linking and its implications.
17
As discussed in section 2.6, the precise weighting system matters. For simplicity, individual year-weights were calculated
using residual fund values. The underlying data are the same as in Figure 4. As with Bunn and Ellis (2012), who construct
hazard functions for price changes, each first fund-level observation is the change between the first and second fund positions
that are observed.
-100
-50
0
50
100
150
200
1995 1997 1999 2001 2003 2005 2007 2009
LPX50
PE index, quadratic interpolation
PE index, LPX50-based interpolation
Percentage changes on a year earlier
17

Figure 6: Chain-weighted PE index



Figure 6 suggests that, overall, the impact of different aggregation methods on benchmarks of PE
returns may not be particularly large.
18
The average annual growth in the chain-weighted index is
13.4%, compared with 11.4% for the simple PE index. However, although this suggests that pooled
estimates of returns can offer a reasonable representation of aggregate performance, investors will
still want to compare these measures of PE returns to other asset classes, and in particular public
equity markets. The next section discusses this in more detail.




18
Barring the very start of the sample, where the data comprised of a relatively small number of funds.
-15
-10
-5
0
5
10
15
20
25
30
35
40
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
Simple pooled PE index
Chain-weighted PE index
Percentage changes on
a year earlier
18

3. Making comparisons with public markets


The previous section discussed methods for measuring PE returns as well as aggregation and
indexation issues. Another key concern for investors is the need to compare returns across asset
classes. Given the nature of IRRs, it is not appropriate to match them against the sort of standard
measures of returns used in other fields; IRRs are not comparable with time-based measures of
returns such as yields on bonds or measures of total returns either from individual equities or public
indices as a whole. In light of this difficulty, this section describes methods for comparing public
markets with IRRs in a meaningful fashion.


3.1 The Public Market Equivalent (PME) method

Given the lack of comparability between IRRs and time-based returns, previous work has examined
how public market data can best be compared with PE returns. One of the most common means of
doing so was devised by Long and Nickels (1996), who proposed the Public Market Equivalent (PME)
method.
19
The PME allows investors to compare IRRs with the returns that public markets would have
yielded over the same timing of cashflows.


Table 4: Illustrative PME return

Date

Unit

PE
fund
data

PME

Public index
value (IV)

PME
NAV
(PMV)

PMV calculation
Year 0 (Y0) Draw down (C0) -80 -80 100 80 = - CY0
Year 1 (Y1) Distribution (C1) 40 40 112 49.6 = PMVY0*(IVY1/IVY0) CY1
Year 2 (Y2) Draw down (C2) -50 -50 110 98.7 = PMVY1*(IVY2/IVY1) CY2
Year 3 (Y3) NAV 120 107.7 120 107.7 = PMVY2*(IVY3/IVY2)
IRR (%) 12.7 7.8


Table 4 presents an illustrative PME calculation. The PME method creates a hypothetical investment
vehicle that exactly mimics private equity cashflows. Because the cashflows are identical, and the
estimation methodology is the same, the difference between the PE IRR and the PME is determined
by the resulting NAV for the hypothetical investment vehicle. This hypothetical NAV is sequentially
calculated by taking draw downs as further investments into the relevant public index, and
distributions as investors selling their shares in it. If the simulated NAV for the hypothetical
investment vehicle is larger than the PE funds NAV then the PE fund has underperformed public
markets, and vice versa.


19
This was originally known as the Index Comparison Method (ICM).
19

3.2 Short positions and PME+

The PME method is relatively simple to use, and allows investors to properly benchmark PE fund
managers against other markets. However, the method also has some limitations. The most obvious of
these is that, depending on the evolution of the public market index, the hypothetical PME vehicle
may end up in a short position, i.e. holding a negative NAV. This could occur when distributions
exceed draw downs in flat underlying markets, or where the cashflows broadly match but market
prices are falling. It will also happen when PE funds outperform public markets and subsequently
close: as the residual valuation of closed PE funds is zero, a negative NAV for the PME vehicle would
result. Comparing a long PE fund with a hypothetical short position in public markets does not
make sense. Furthermore, such short positions may even result in nonsensical or incalculable IRRs.
As such, various modifications have been proposed.

In particular, Rouvinez (2003) has proposed the PME+ method. This essentially applies the logic of
the PME in a different way. In the PME approach, the cashflows are assumed to be identical between
the PE fund and the hypothetical investment vehicle, with only the NAVs differing. As the IRR
calculation is the same, this means that this difference in the NAVs drives the difference in between
the estimates of returns. With PME+, a different hypothetical vehicle is constructed. This time the
NAV of the PE fund and the PME+ vehicle are the same, and instead the distributions of the PE funds
are adjusted by a scaling factor that ensures that the NAVs are identical. As these distributions
represent investors selling securities in the PME+ model, this makes sure that the PME+ vehicle does
not end up having to sell more securities than it actually owns.
20


Technically, the scaling factor is calculated as:

where

and CC denotes capital calls (draw downs), D denotes distributions, and I denotes the public index
used for the comparison, and N is the final time period considered. The PME+ is therefore more
computationally intensive than the PME. But if PE funds have outperformed public markets in the

20
One alternative adjustment is to restrict the distribution from the hypothetical vehicle to be no greater than its current NAV.
20

past, this extra complexity is necessary to avoid the problem of short positions in the hypothetical
vehicle.
21



3.3 Choosing the appropriate public index

In principle both the PME and PME+ methods can be used to compare the performance of PE funds
to any other asset class. In practice, there are two mainstays in most investment managers portfolios:
fixed income securities and public equities. For both of these asset classes it is most appropriate to
consider the total return indices, which take account of coupon payments and dividends. Total return
indices for the FTSE All Share and UK gilts are shown in Figure 7 below.


Figure 7: Total return indices for UK public markets

Source: Bloomberg


The simplest way of constructing a PME/PME+ estimate is to use these aggregate indices in
constructing the hypothetical investment vehicle. However, in practice previous research has
suggested that sector-selection can play a part in driving PE fund returns (Gottschalg et al, 2010). As
such, when benchmarking against public markets, investors may wish to use the PME/PME+ method
not on the basis of a published equity index as a whole, but construct specific and representative
industry mixes from public markets. For simplicity, however, we use the broad FTSE All Share total
return index.

Using both the PME and PME+ approach, the PMS data indicate that PE funds have significantly
outperformed public equity benchmarks since 1986 (Figure 8). This chimes with recent research from
Harris et al (2011), which revised and updated the seminal paper by Kaplan and Schoar (2005).

21
One potential issue with PME+ is that distributions are scaled (partly) based on the final ratio of NAV to the public index.
Depending on how this ratio evolved over time, this could potentially depress PME+ IRRs.
50
70
90
110
130
150
170
190
210
230
1998 2000 2002 2004 2006 2008 2010 2012
FTSE All Share
Gilts
Indices, 1 Jan 1999 = 100
21

Figure 8: Comparing UK PE funds with PME and PME+ (a)

(a) 1987 vintage funds onwards.

However, while these return estimates are now comparable, they still have different characteristics. In
particular, the PME/PME+ method makes no adjustment for the illiquid nature of PE investments.
Furthermore, the absolute performance of the different assets does not address an important
consideration for portfolio managers: how to allocate capital among different asset classes. The next
section touches on this, in the context of cross-sectional return variation.


3.4 Correlation analysis: time series vs. cross section

Using commonly applied techniques, we have demonstrated that UK PE funds have, overall,
outperformed public equity markets over the past 25 years. However, headline performance is not the
only relevant factor when investors are considering different asset classes. The degree of covariance
between asset classes also matters.
22




22
For more detail on the capital asset pricing model (CAPM) with representative agents, see Cochrane and Hansen (1992).
0
2
4
6
8
10
12
14
16
IRR PME PME+
Percentage return per annum
22

Figure 9: Evolving IRRs


A common means of estimating the co-movement between PE funds and public markets is to track the
returns over time. Figure 9 shows since-inception IRRs based on the BVCA PMS and the equivalent
PME (based on the FTSE All Share) from 1988.
23
Over the sample as a whole the correlation between
the two series is 0.18. Since 1996, when the UK PE market is generally considered to be more mature,
the correlation is 0.23.

This positive correlation between PE returns and the FTSE PME is unsurprising. One of the valuation
methods for unrealised PE investments is to use public market ratios, such as earnings (or EBITDA)
to revenues. If public markets rise, then so will NAVs calculated on this basis, leading to positive
correlation. However, by construction the series in Figure 9 will suffer from a degree of serial
correlation that could affect estimates of covariance between the two series.
24
In addition, previous
work in other economic fields by Imbs et al (2005) and Mumtaz et al (2009) has demonstrated that
aggregation bias can result in sector-wide series exhibiting different time-series properties than the
underlying individual data series.

In light of this, it is also appropriate to consider the cross-sectional correlation between PE funds and
public markets. Rather than aggregating across PE funds and constructing metrics of public returns,
an alternative is to construct PME equivalents for each PE fund individually. We can then examine the
cross-sectional return between the individual PE fund IRRs and their hypothetical PME vehicles.

The results from this approach, using PMS data, are shown in Figure 10 for closed funds and Figure 11
for open funds, respectively.
25
Because a significant number of funds in the PMS are closed, and

23
The returns are calculated on a pooled basis, showing the total return across all funds at the date shown.
24
This may be less visible in the FTSE All-Share return if equity markets are volatile.
25
For this exercise, we define funds as closed if they have zero residual valuations for two or more years. Where PME+/IRR
calculations did not solve, these funds were excluded.
-20
-15
-10
-5
0
5
10
15
20
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Since-inception PMS
FTSE All-Share (PME+)
Per cent per annum
23

performed relatively well, we used the PME+ approach to calculate public market performance, to
avoid concerns about short positions.

Figure 10: Cross-sectional correlations between closed PE funds and public markets



Figures 10 and 11 illustrate the extent to which unrealised valuations influence the correlation
between PE returns and public markets. For closed funds the correlation between PE returns and the
FTSE All-Share is 0.29, although that falls to 0.11 when the four outliers are excluded; this is both
statistically insignificant and lower than the time-series result. For open funds, however, the
correlation is much higher (and statistically significant) at 0.42. A comparison of the two charts also
illustrates the uncertainty around PE valuations, which can be substantial (Ellis & Steer, 2011).
Overall, these results suggest that the observed correlation between PE funds and public markets may
largely reflect interim PE valuations, which by construction partly reflect public equity prices. At the
same time, it is not suggestive of a simple buy and hold approach with leverage, where the PE fund
has little impact on the investee companys performance.
26
If that were the case, we would expect a
higher correlation between the returns of closed funds and public markets.




26
This is consistent with recent evidence from Kaserer (2011).
-30
-20
-10
0
10
20
30
40
-60 -40 -20 0 20 40 60 80
Fund IRR (%)
FTSE All-Share (PME+, %)
24

Figure 11: Cross-sectional correlations between open PE funds and public markets




-80
-60
-40
-20
0
20
40
60
80
100
-100 -50 0 50 100 150
Fund IRR (%)
FTSE All-Share (PME+, %)
25

4. Summary & conclusions


The illiquid nature of private equity investments, and the irregular timing of cashflows both from
investors to fund managers and vice versa, mean that private equity returns are typically measured in
a different manner to other asset classes. In particular, the main measure of performance is typically
the internal rate of return (IRR). As a non-linear denominator-based measure of returns, IRRs are not
comparable with typical denominator-based measures of returns. Care must also be taken when
looking at PE performance over a short-term or backward-looking basis. The best way to use IRRs is
to look at fund performance on a since inception basis.

This paper has also discussed other issues that investors must consider when looking at IRRs as
measures of returns, and described simple methods for benchmarking PE funds against other asset
classes (in particular public equity markets). We have also described how indices can be constructed
from PE cashflow data and demonstrated the importance of considering cross-sectional covariance as
well as time series behaviour. For the former, it is crucial to differentiate between open and closed
funds. Provided investors have some awareness of the nature of IRRs and their characteristics, used
properly they can offer a good guide to PE returns. The BVCA is committed to providing this guidance
to investors through its annual Performance Measurement Survey, and will continue to break new
ground in this field.







26

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