3.1 Benchmark Selection & Public Market Equivalent (PME)
Key Takeaways
- Peer group benchmarking evaluates private fund returns against funds of identical vintage year and strategy, but suffers from survivorship, selection, and backfill biases.
- Kaplan-Schoar PME (KS-PME) measures outperformance by ratioing discounted fund distributions plus remaining NAV to discounted capital calls using market index returns.
- A KS-PME greater than 1.0 indicates private fund outperformance relative to public markets, while less than 1.0 signals underperformance net of opportunity cost.
- Long-Nickels PME (LN-PME) creates a public index tracking portfolio matching the timing of private cash flows, yielding an equivalent public market IRR.
- Private market benchmarks are distorted by illiquidity delays, self-reporting selectivity, and historical backfilling of successful track records.
Evaluating performance in private alternative investments presents unique challenges compared to public equities and fixed income. Private market asset classes—such as private equity, venture capital, private credit, and real estate—feature irregular, manager-driven cash flows, substantial illiquidity, delayed valuations, and a lack of standardized secondary trading pricing. Consequently, traditional public market metrics like the Sharpe ratio or time-weighted returns (TWR) fail to capture true risk-adjusted performance. Institutional investors rely on specialized benchmarking techniques, primarily peer group comparisons and Public Market Equivalent (PME) methodologies, while remaining vigilant against systematic data biases.
Peer Group Benchmarking & Performance Universes
Peer group benchmarking compares a fund's internal rate of return (IRR) or multiple on invested capital (MOIC) against a cohort of funds launched in the same vintage year that pursue identical investment strategies and geographic focuses. A fund's vintage year is typically defined as the year in which the fund makes its first capital call or completes its initial portfolio investment.
Construction and Quartile Rankings
Performance providers aggregate cash flow and valuation data submitted by general partners (GPs) or limited partners (LPs). Funds within a vintage-strategy universe are ranked by IRR or TVPI (Total Value to Paid-In capital) into quartiles:
- Top Quartile (1st Quartile): Funds performing in the top 25% of their peer universe.
- Median (2nd/3rd Quartile Boundary): The middle-performing fund return.
- Bottom Quartile (4th Quartile): Funds performing in the lowest 25%.
Limitations of Peer Group Benchmarking
While peer group analysis is widely utilized, it exhibits critical analytical limitations:
- Uncalled Capital and Cash Flow Timing: Two funds with identical final returns may experience vastly different cash flow drawdown schedules, altering investor opportunity costs.
- Stale Valuations: Mid-life fund rankings rely on Net Asset Values (NAVs) estimated by GPs rather than realized cash distributions.
- Lack of Timeliness: Peer group data typically lags actual market events by 3 to 6 months due to private reporting schedules.
Biases in Private Market Performance Data
Private market benchmarks are heavily affected by three primary measurement biases that artificially inflate historical benchmark returns and distort risk assessments.
| Bias Type | Definition & Mechanism | Impact on Benchmark Return |
|---|---|---|
| Survivorship Bias | Failed or liquidated funds cease reporting data to benchmark databases, leaving only surviving, successful funds in the historical sample. | Overstates historical average returns and understates fund failure rates. |
| Selection Bias | Reporting data to commercial databases is voluntary; high-performing managers self-report to attract capital, while poor performers abstain. | Artificially elevates median and average peer group benchmarks. |
| Backfill (Instant History) Bias | Newly included funds add their prior historical performance track record to a database only after achieving strong results. | Creates an upward historical bias by omitting funds that failed prior to database inclusion. |
Custom Benchmarks & Asset-Based Indices
To overcome peer group limitations, investors construct customized benchmarks tailored to specific mandate objectives:
- Blended Public Indices: Combining broad public market indices with a fixed spread (e.g., MSCI World + 300 bps) to reflect illiquidity premiums.
- Absolute Return / Hurdle Benchmarks: Utilizing fixed target rates (e.g., 8% annual hurdle) combined with inflation metrics (CPI + 500 bps).
- Risk-Adjusted Custom Benchmarks: Deconstructing private portfolio asset exposures into public equivalents using factor risk models.
Public Market Equivalent (PME) Methodologies
Public Market Equivalent (PME) metrics solve the cash flow timing mismatch by evaluating private fund cash flows against the opportunity cost of investing those exact same cash flows into a public market index.
1. Kaplan-Schoar PME (KS-PME)
The Kaplan-Schoar PME calculates the ratio of the sum of discounted fund distributions (plus current NAV) to the sum of discounted capital calls. Each cash flow is discounted using the realized return of a chosen public market index from the date of the cash flow to the evaluation date (T).
Where:
- (D_t) = Distribution received by LP at time (t)
- (C_t) = Capital call drawn from LP at time (t)
- (\text{NAV}_T) = Remaining fund Net Asset Value at evaluation date (T)
- (I_t) = Public market index level at time (t)
- (I_T) = Public market index level at evaluation date (T)
Interpretation of KS-PME:
- KS-PME > 1.0: The private fund outperformed the public benchmark after accounting for exact cash flow timing.
- KS-PME = 1.0: The fund's performance exactly equaled public market index returns.
- KS-PME < 1.0: The private fund underperformed the public market index.
Worked Example: KS-PME Calculation
Consider an LP investment in a buyout fund over a 2-year horizon with the public index levels shown:
| Year ((t)) | Fund Cash Flow ($M) | Public Index Level ((I_t)) | Index Growth Factor ((I_T / I_t)) | Discounted Cash Flow ($M) |
|---|---|---|---|---|
| Year 0 | Capital Call: -$100 | 1,000 | 1,200 / 1,000 = 1.20 | Call: $100 \times 1.20 = $120.00 |
| Year 1 | Distribution: +$30 | 1,100 | 1,200 / 1,100 = 1.0909 | Dist: $30 \times 1.0909 = $32.73 |
| Year 2 | Distribution: +$100 | 1,200 | 1,200 / 1,200 = 1.0000 | Dist: $100 \times 1.0000 = $100.00 |
| Year 2 | Ending NAV: $10 | 1,200 | 1,200 / 1,200 = 1.0000 | NAV: $10 \times 1.0000 = $10.00 |
Because the KS-PME is 1.189 (greater than 1.0), the private fund outperformed the public market index by approximately 18.9% on a value-added ratio basis.
2. Long-Nickels PME (LN-PME)
The Long-Nickels PME constructs a hypothetical public index investment portfolio. Every capital call into the private fund triggers a purchase of the public index, and every private distribution triggers a sale of the public index. An internal rate of return (IRR) is then calculated on the resulting public market index investment series and directly compared against the private fund IRR.
- Key Distinction: LN-PME produces an annualized rate of return (IRR difference), whereas KS-PME produces a market-adjusted wealth multiple ratio.
Which of the following biases in private equity peer benchmarks occurs when failed funds drop out of historical databases, thereby overstating historical returns?
An institutional investor calculates a Kaplan-Schoar Public Market Equivalent (KS-PME) ratio of 0.88 for a venture capital fund. How should this result be interpreted?
What is the primary methodological distinction between Kaplan-Schoar PME (KS-PME) and Long-Nickels PME (LN-PME)?