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Public market equivalent (PME) is a methodology for assessing the performance of a private equity fund relative to a public equity benchmark. PME is one method to determine whether a private equity fund or manager is providing performance alpha.
Several types of PMEs have been developed for this purpose. The initial PME methodology was developed by Austin M. Long and Craig J. Nickels in 1996. The authors call it the Index Comparison Method (ICM), though it is also known as the Long Nickels PME, LN-PME, or simply PME.
The LN-PME compares the performance of a private equity fund with the S&P 500 Index by creating a theoretical investment in the index using the cash flows from the private equity fund and then determining the IRR of the theoretical investment. That means capital calls are assumed to buy the index and distributions are assumed to sell the index. The return of the fund can then be compared to the return of the hypothetical investment to determine whether there is positive or negative alpha.
Other variations of the PME include the PME+, Modified PME, Kaplan Schoar (KS-PME), Direct Alpha and Excess IRR.
Several problems are incurred when assessing the performance of private equity funds:
PME methodologies attempt to solve some of these issues by measuring the hypothetical return that would result from deploying a private equity fund's cash flows into a benchmark equity market index.
PME offers another way to assess the performance of a private equity fund and compare it to the performance of a well-known benchmark.
The PME is an IRR on the cash flows of the investment, using as final cashflow an adjusted PME NAV. The formula for PME is:
Where:
C is the cash flow from the investment at date s (positive for a contribution, negative for a distribution)
NAV is the value of the index at date s
PME = IRR(Cs, NAVPME)
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Enroll in Moonfare’s free Private Equity Starter Course. In six emails, you’ll learn the essentials of the asset class and how it could transform your portfolio.
PME is a theoretical construct. Therefore, its resulting IRR can, at best, serve as an approximation. The biggest issue with regard to PME calculations is the relevance of the index as an appropriate benchmark for the PE fund. The technique does not make an adjustment for the difference in risk between the PE fund and the public equity index. Therefore, a higher IRR for the theoretical investment may be reflecting a higher risk rather than the alpha of the PE fund manager.
Additionally, a Long Nickel PME can produce negative values for the theoretical investment if large distributions occur from the PE fund at a time when the benchmark index is falling. This can preclude the ability to calculate an appropriate IRR from the theoretical investment.
The table below compares the top four methodologies for determining PME.
Since public equity indexes are familiar benchmarks to investors and they may want to compare public vs. private equity investment opportunities, a PME methodology can be used to assess the returns from private equity funds to a public equity index. While PME is a theoretical approach, it can provide a perspective on the differences in performance of various types of PE funds and managers vis a vis a public equity index and help to determine whether a private equity manager has been providing alpha as well.
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