Investment Theory and Risk Management, + Website

Return and Risk Methodology

Measurement issues arise for nonpublicly traded assets for a host of reasons, for example, relative illiquidity, stale pricing, and irregularly timed cash flows, which confound attempts to compute standard time-weighted returns typical of publicly traded assets. Dollar-weighted measures, such as IRR, are most frequently reported but are not without their problems. For example, cash flows are not necessarily reinvested over the life of the fund at the measured internal rate of return as implicitly assumed. Neither can IRR be compared with time-weighted return, nor does IRR measure the opportunity cost of capital. We follow up on these criticisms in the discussion further on.

Public market equivalents are directed at measuring the opportunity cost of capital. These are mimicking portfolios that invest private equity cash flows in a publicly traded benchmark (for example, the S&P 500). Total dollars that would have accumulated in the benchmark are then compared to the dollars earned in the private equity investment. Indexing dollar distributions at time t by D_i and drawdowns, or dollar capital calls, by C_j and assuming the fund lives T periods, then with continuous compounding, PME is the ratio of the value of the private equity investment (distributions are reinvested in the benchmark) to the opportunity cost of funds:

Private equity's excess return over ...