Kaplan Schoar Public Market Equivalent Approach

Understanding the universal concept behind Kaplan Schoar PME

On the history of public market equivalent approaches 1

Public Market Equivalent (PME) approaches are developed to measure the investment success of private equity funds in terms of public markets.

Long Nickels (1996) elaborated on the first public market benchmarking method, called the Index Comparison Method (ICM).

More incidentally, Kaplan Schoar (2005) proposed the now-famous KS-PME ratio as “a sensible measure for LPs as it reflects the return to private equity investments relative to public equities”.

Many people believe that these PME approaches of Long Nickels (1996) and Kaplan Schoar (2005) are two rather distinct concepts.

However, Long (2008) showed that both PME measures are based on a common mathematical foundation.

How to gauge private investment success using the Long Nickels (1996) and Kaplan Schoar (2005) methods? 2

Let’s denote contribution cash flows by C_t and distribution cash flows by D_t for a fully realized private equity fund. The dates of private equity fund cash flows are denoted by the time index t=1,2,…,T. The public market index we use for benchmarking is denoted by I_t. According to Long Nickels (1996), a private equity fund outperformed the public index, if

    \[  LN-PME = \sum_{t=1}^T \frac{D_t}{I_t} - \sum_{t=1}^T \frac{C_t}{I_t} > 0  \]

According to Kaplan Schoar (2005), a private equity fund outperformed the public index, if

    \[  KS-PME = \frac{ \sum_{t=1}^T \frac{D_t}{I_t} }{ \sum_{t=1}^T \frac{C_t}{I_t} } > 1 \]

For Long Nickels (1996), you take the difference; for Kaplan Schoar (2005), you take the ratio – that is the only main difference.

Numeraire denomination as a common foundation 3

Many people share the concern that both approaches lack a systematic risk adjustment. However, Sorensen Jagannathan (2015) discussed why systematic risk adjustments are unnecessary under relatively mild assumptions.

The general validity of those PME methods originates from a financial mathematics concept called ‘numeraire denomination’.

Numeraire denomination is one of the most essential and universal concepts that financial mathematicians apply (almost) all the time.

The idea behind numeraire denomination is strikingly simple: divide all cash flows, security prices, etc. that appear in a financial model by a (default-free) public index. To satisfy the next fundamental concept in financial mathematics called ‘martingale property’, you should choose a broadly diversified public index as the denominator.

That’s it!

Lesson learned 4

Kaplan Schoar (2005) PME is really straightforward and very similar to the Long Nickels (1996) approach: divide all private cash flows you encounter by a broad public index, as all financial economists and mathematicians approve it!

And in consequence, as the method is easy to implement and understand, all practitioners should likewise embrace it!

Of course, it is also a vital component of the AssetMetrix benchmarking module!

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AssetMetrix is Europe’s leading next generation asset servicer. We offer modular outsourcing solutions for private capital investors: front-, middle- and back-office solutions for Limited Partners and General Partners.

Our services enable private capital investors to free up their own resources for making investment decisions, benefit from our secure IT system and state-of-the-art analytics, and increase in-house transparency for optimal decision-making.

AssetMetrix has more than 20 years of experience as a service provider in institutional capital investment and operates without conflicts of interest. AssetMetrix is not an investor, an investment consultant, or a placement agent, but currently administers portfolios with a total volume of over €12 billion and more than 1500 funds.

Citations

  1. Long, Austin M., and Craig J. Nickels. “A private investment benchmark.” Working paper (1996).
  2. Kaplan, Steven N., and Antoinette Schoar. “Private equity performance: Returns, persistence, and capital flows.” The journal of finance 60.4 (2005): 1791-1823.
  3. Long, Austin. “The common mathematical foundation of ACG’s ICM and AICM and the K&S PME.” Alignment Capital Group, Research Paper (2008).
  4. Sorensen, Morten, and Ravi Jagannathan. ”The public market equivalent and private equity performance.” Financial Analysts Journal 71.4 (2015): 43-50.

Author

Christian Tausch
Analytics

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