​This one of a series of posts on fund performance metrics.  Other posts in this series include:

• LP Corner: Private Equity Fund Performance – An Overview
• LP Corner: Fund Performance Metrics – Multiples TVPI, DPI and RVPI
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part One
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part Two
• LP Corner: Fund Performance Metrics – Public Market Equivalent (PME) - This blog post.
• LP Corner: Fund Performance Metrics - Private Equity Fund Performance
• LP Corner: Gross vs Net Returns
  

 
We have now discussed two of the three primary metrics uses to evaluate the performance of private equity funds: (1) the multiples TVPI, DPI and RVPI; and (2) IRR.  We will now explore the third primary metric: Public Market Equivalent, or PME.
 
Overview
Broadly speaking, PME is a return metric that compares the return of a private equity fund (or a portfolio of funds) to the hypothetical return of a chosen public stock market index, such as the S&P 500 or Nasdaq, using the cash flows as the fund as a basis for investment in the stock market index.  For example, a fund may have an IRR of 15%, while the PME obtained using the S&P 500 as the index is 10%, suggesting that the fund has outperformed the S&P 500 by 500 basis points (bps).
 
There are several variations of PME, but these are commonly used:

• LN PME, developed by Austin Long and Craig Nickels in 1996
• PME+, developed by Capital Dynamics in 2003
• KS PME, developed by Steve Kaplan and Antoinette Schoar in 2005
• mPME, developed by Cambridge Associates and introduced in 2013
• Direct Alpha, developed by Oleg Gredil, Barry Griffiths and Rüdiger Stucke in 2014

 
LN PME
The LN PME (also known as the Index Comparison Method or ICM) is widely considered the “first” PME approach (and it is often referred to simply as “PME”).  The LN PME matches each contribution and distribution of a fund with a hypothetical purchase and sale of a reference public market index, such as the S&P 500.  The residual value of the fund is not matched to the LN PME; rather, the LN PME residual value is based on the performance of the hypothetical invested capital in the index.  With these cash flows, an LN PME return for the public market index is compared directly against the IRR for the fund.  If the fund’s IRR exceeds the LN PME, then the fund has outperformed the public market index.  If the LN PME IRR exceeds the fund’s IRR, then the fund has underperformed the public market index.  Note that the IRR generated using LN PME isn’t a “real” IRR – it’s an estimation because of the manipulation of the residual value.
 
One nice thing about the LN PME is that it is conceptually straightforward.  However, the mechanics of LN PME have some issues.  One issue for the LN PME approach is that the residual value for the PME index can be negative.  This can occur if the fund has distributions early in the life of the fund, or has a series of large distributions late in the life of the fund.  The problem is that a fund can’t have a negative residual value (technically a fund could have a negative residual value, but it would be a very rare case).  As a result, LN PME isn’t used very often in private equity.  The other forms of PME attempt to address the drawbacks of the LN PME.
 
Let’s look at an example:
 
First consider the fund that we want to evaluate.  The fund is presented below:

This one of a series of posts on fund performance metrics.  Other posts in this series include:

• LP Corner: Private Equity Fund Performance – An Overview
• LP Corner: Fund Performance Metrics – Multiples TVPI, DPI and RVPI
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part One
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part Two - This blog post
• LP Corner: Fund Performance Metrics – Public Market Equivalent (PME)
• LP Corner: Fund Performance Metrics - Private Equity Fund Performance
• LP Corner: Gross vs Net Returns
  

In this post, we will explore internal rate of return (IRR) as a tool for evaluating fund performance metrics.
 
Recap
In my prior post, we discussed the basics of IRR in a fund context.  In this post, we build on that to explore what happens year by year for that fund.
 
In Example 1 in the last post, we introduced a fund, where the LP paid $30 million to the fund in a capital call at time = 0 and received $80 million back from the fund (as distributions) at the end of year 5.  These simple cash flows yielded an IRR of 22% and a TVPI of 2.67x.

​

This one of a series of posts on fund performance metrics.  Other posts in this series include:

• LP Corner: Private Equity Fund Performance – An Overview
• LP Corner: Fund Performance Metrics – Multiples TVPI, DPI and RVPI
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part One - This blog post.
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part Two
• LP Corner: Fund Performance Metrics – Public Market Equivalent (PME)
• LP Corner: Fund Performance Metrics - Private Equity Fund Performance
• LP Corner: Gross vs Net Returns

In this post and the next post, we will explore measuring fund performance using internal rate of return or IRR. This post will provide an overview of IRR.  If you already have a good grasp of IRR, you can move to part two of this series: LP Corner: Fund Performance Metrics - Internal Rate of Return (IRR) - Part Two.
 
IRR Overview
In a basic sense, IRR is the return from a series of cash flows over time.  In the Private Equity space, IRR is commonly used to evaluate the performance of private equity (including venture capital, growth equity and buyout) funds.  IRR is best calculated using Excel, Google Sheets or another financial spreadsheet program.
 
Simple IRR Examples
Let’s assume that an LP commits $30 million to a fund, and that the fund returns $80 million in distributions to the LP.  (For a discussion on committed capital, see "LP Corner: On Committed Capital, Called Capital and Uncalled Capital.") On a multiple basis, this equates to a Total Value to Paid-in-Capital (TVPI) of 2.67x ($80M / $30M) – which sounds pretty good.  But let’s explore a bit deeper.

Note that in these examples, we are looking at cash flows from the perspective of an LP - payments made by the LP and money received by the LP.  This is known as a "Net IRR" because it focuses on the cash flows to and from the LP.  For a discussion of gross vs net returns, see "LP corner: Private Equity Fund Performance - An Overview."

Example 1:  Assume that when the fund has its closing (which is time 0 for purposes of calculating the IRR in Excel), it calls all capital from the LP (in reality, this doesn’t happen, but humor me as this is an example).  In five years, the fund distributes $80 to the LP.  This looks like this:

This one of a series of posts on fund performance metrics.  Other posts in this series include:

• LP Corner: Private Equity Fund Performance – An Overview
• LP Corner: Fund Performance Metrics – Multiples TVPI, DPI and RVPI - this blog post.
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part One
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part Two
• LP Corner: Fund Performance Metrics – Public Market Equivalent (PME)
• LP Corner: Fund Performance Metrics - Private Equity Fund Performance
• LP Corner: Gross vs Net Returns
  

In this post, we will explore using multiples as a tool to evaluate fund performance.
 
The multiples are:

• Distributions to Paid-in-Capital, or DPI
• Residual Value to Paid-in-Capital, or RVPI
• Total Value to Paid-in-Capital, or TVPI

 
Here’s some important terminology that will help explain the multiples:

• Paid-in-Capital = the capital contributed by LPs to the fund.  Paid-in-capital is also known as “contributed capital” or “called capital” or sometimes “drawn capital.”  Note that Paid-in-Capital is different than Committed Capital.  Recall that an investment in a private equity fund occurs over time.  An investor in the fund, known as a limited partner or LP, agrees (commits) to invest a certain amount in a fund, say $10 million, as and when the manager of the fund, known as a general partner or GP, needs the capital.  In this case, the $10 million is the LP’s commitment.  As the GP asks for a portion of this commitment (known as a “call”), the amount paid by the LP to the fund is known as Paid-in-Capital, or PIC (this is also known as “called capital”).
• Distributions = the value of the cash and stock that the fund has given back (distributed) to the LPs.  Distributions are typically low early in a fund’s life, ramping up over time as investments are exited.
• Residual Value = the remaining value of the fund at a given point in time.  Residual value is the value of the fund’s investments plus other fund assets (cash, etc.) less fund liabilities.  So, for example, if the fund has 12 remaining investments with an aggregate estimated fair value of $100 million and another $3 million in cash, the Residual Value of the Fund is $103 million.  Early in a fund’s life when investments are being made residual value is typically high (reflecting the value of the investments) and declines over time as the fund exits its investments and makes distributions to the LPs.
• Total Value = the total value of the fund, which is the sum of the distributions and the residual (remaining) value of the fund at a given point in time.  The mathematical relationship among these metrics is:

​​​To better understand the above terminology, let’s look at the terms graphically:
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