1. Lecture 2: Performance Measurement in a Nutshell Jesse Reyes

2. What are we measuring and why is it so difficult
Overview
What are we measuring and why is it so difficult
What/how do we benchmark
Industry performance

3. Date Return 12/31/11 12/31/12 10% 12/31/13 20% 12/31/14 -30% 12/31/15
QUIZ TIME
Date
Return
12/31/11
12/31/12
10%
12/31/13
20%
12/31/14
-30%
12/31/15
50%
WHAT IS THE AVG ANNUAL RETURN?

4. Date Return 12/31/11 12/31/12 -30% 12/31/13 -50% 12/31/14 20% 12/31/15
QUIZ TIME
Date
Return
12/31/11
12/31/12
-30%
12/31/13
-50%
12/31/14
20%
12/31/15
10%
WHAT IS THE AVG ANNUAL RETURN?

5. QUIZ TIME
Date
Index
12/31/11
1000
12/31/12
1100
12/31/13
1320
12/31/14
924
12/31/15
1386
WHAT IS THE ANNUAL RETURN From 12/31/11 to 12/31/15?

6. QUIZ TIME
Date
Index
12/31/11
1000
12/31/12
700
12/31/13
1050
12/31/14
1260
12/31/15
1386
WHAT IS THE ANNUAL RETURN From 12/31/11 to 12/31/15?

7. “Our/Some Fund Has a Return of 300 Percent” Is that good? Depends?
Typical Question
“Our/Some Fund Has a Return of 300 Percent”
Is that good?
Depends?

8. Time Weighted/IRR/Realization/Horizon?
Depends on What?
Over What Time period
Over Two Years -- great at 173% per year
Over Ten? --- hmmm!! At 11.61%
Is it return on the investments the fund made or is it the return to the investors in the fund.
Time Weighted/IRR/Realization/Horizon?

9. Example 1
Invest $1.5 million
Worth $5 million
What is the return?

10. 5/1.5=333% Total Return or percentage change of 233%
What is the Return?
Invest $1.5 million
Worth $5 million
What is the return?
5/1.5=333% Total Return or percentage change of 233%
Note – we haven’t defined a time period

11. Worth $5 million five years later What is the return?
Example 2
Invest $1.5 million
Worth $5 million five years later
What is the return?

12. Example 2 What is the Return?
Invest $1.5 million
Worth $5 million five years later
What is the return?
5/1.5 = 333% Total Return
Lets annualize with formula (total return)^(1/5) -1 = 27.2%
This is the annual rate of return (compound annual growth rate, Geometric average return, Time weighted return, etc)

13. Worth $5 million at the end of year five
Example 3?
Invest .5 in three years
.5 at the beginning of year 1
.5 at the beginning of year 2
.5 at the beginning of year 3
Worth $5 million at the end of year five

14. Why The difference?
First two examples are just examining two points in time. i.e .today and some point in the past.
No transactions or cashflows occurred in the in between.
The third example, complicated the calculations because we didn’t invest the $1.5 all at once.
Notice that stock indices use the first approach-you only calculate returns at two points in time – assumes that you buy and hold.
The third has shortened the average investment holding period so the time value of money says that the return is higher other things being equal.

15. Why The difference?
Gets even more complicated if we measure returns for an investment where we also take money out over a period of time as well as put money in over a period of time.

16. Why The difference?
Same with your savings account – if you put money in at one point and take it out at another point, you can calculate the return for that period of time which will be the APR, but if you put money in, take money out over a period time, the actual return over the life of your investment getting is not the APR but something different that depends on the average time you held the money. The APR assumes you put money in a lump and hold it

17. Why The difference?
You have the same complications if you measure the return to an investment manager/mutual fund in public stocks --money goes in at different points in time, and is taken out at different points in time by the investor. – more on this later.
Don’t have this complication with a simple stock index – you are just measuring values at two points in time – no transactions in the middle, so you can use time weighted/total return calculations

18. So what do we do?
So with investments either in private equity or any investment manager, if you have cashflows in and out of an investment simple percentage change/total return calculations can no longer be done to get the true Return on investment. So we turn to IRR, a form of ROI that takes the time value of money into account as it accounts for the timing of the transactions in the investment.

19. Example 3 What is the Return?
Invest .5 in three years
.5 at the beginning of year 1
.5 at the beginning of year 2
.5 at the beginning of year 3
Worth $5 million five years later
What is the return?
5/1.5 = 333% Total Return
IRR = 46.97% annual IRR
Compare to return on example 2 of 27.2% annualized

20. Distributions – cash or stock returned to LP investors.
Definitions
Takedown – actual money paid into partnerships, aka capital calls, paid in capital
Distributions – cash or stock returned to LP investors.
NAV – aka residual value, ending value of the fund for the period being measured – net of fees and carry

21. Definitions continued
Vintage Year -- year fund started investing
IRR -- Net to investor after fees and carry
DPI -- cumulative distribution/cumulative Paid in capital – cash in – cash out (CICO)
RVPI -- net asset value / cumulative paid in capital
TVPI -- DPI + RVPI
PICC-- cumulative paid in capital to committed capital (dry powder ratio)

22. Cumulative Realization Multiples (Cash-in/Cash-out)
Principal metrics
Cumulative IRR
Cumulative Realization Multiples (Cash-in/Cash-out)
Time Weighted Return
Public Market Comparables – Index method

23. Realized Investment Multiples
Other valid measures
Realized Investment Multiples
Cash on Cash (CICO) (cash in cash out)
Ignore NAV – measure ratio of cumulative distributions since inception to cumulative paid in capital since inception (DPI) – measure of realized return
Unrealized Investment multiple
How much of the return is unrealized and still locked up in portfolio company investments – ratio of ending NAV (residual value) to cumulative paid in capital (RVPI)
Total Investment Multiple – the addition of the the two (TVPI ) total value to paid in capital ratio

24. Intro to Fund accounting for performance (kindergarten version)
Done from LP perspective
Three inputs: Cash in, cash out, terminal net asset value
Contributions (also known as capital calls or paid-in capital or takedowns) increase net asset value. In cashflow analysis these are treated as negative numbers (cash in)
Distributions (either in cash or in stock) decrease net asset value. In cashflow analysis, these are treated as positive numbers (cash out)
Net Asset Value-(net of fees and carried interest) is treated as a positive number
Note: Management fees are either deducted from net asset value or are billed to the limited partner as another contribution. In either case they decrease net asset value. But timing of fee recognition is huge issue.
Net asset value ultimately is determined by the underlying value of the assets/companies being held so it may increase/decrease depending on value of those investments.

25. Principal measure of Fund Returns
Principal metric is IRR since inception
Beginning Point is fixed, endpoint is variable
Principal Composite is “Vintage Year” (designating at the year of the first capital call)
IRR is calculated net to limited partner

26. Time Weighted Returns
Time weighted return calculates a return for each period -- quarterly, annually.
Beginning point is variable, endpoint is variable
Calculate using net asset value at beginning and end of period and cashflows between periods.
Calculate return for each period and then compound together

27. Time Weighted Returns - Shortfalls
Creates aberrations:
% = 120
% = 96
Periodic valuations heavily dependent on valuations. Wrong valuations affect future returns.
Assumes money can come and go freely at the beginning and end of each period

28. Kindergarten Financial Math
FV=Future value, PV=Present Value, r rate of return, n=number of periods

29. Internal Rate of Return,
IRR=internal rate of return, n=period ,of cashflow, N=total periods, CF= cashflow

30. Time weighted Return – Periodic returns
Periodic Returns can be calculated
Before modern math based tools
Dietz mid-point weighted
Modified Dietz
Now IRR can be calculated readily but Dietze is still prevalent
Returns are calculated for each sub period then they are linked and geometically averaged
True time weighed calcuates a return every time there is a transaction
Practical time weighted return calculates return on a periodic interval (daily/monthly/yearly)
Private equity can practically only calculate returns quarterily as that’s as frequent as funds are valued

31. Before the IRR and even now Dietz Midpoint and Modified Dietz
BMV=Beginning Market Value, EMV=Ending Marketin Value, CF=interim cashflow, W=percent of time cashflow was in portfolio

32. Why can’t we all be friends?
Is the IRR all that Bad?
Why can’t we all be friends?

33. Myths every good MBA knows about IRR
Myth #1: IRR is inferior to NPV
Myth #2:IRR can give you different results than NPV
Myth #3: IRR can give you Indeterminate multiple solutions with cashflow sign changes
Myth #4: IRR is flawed because of single re-investment rate assumption
Myth #5: IRR is inferior to other techniques such as modified IRR.

34. Yes Virginia,
There are Private Equity Benchmarks

35. What are you comparing to?
Returns
Performance

36. Returns
Performance
Benchmarks

37. Everything I learned about benchmarking
I learned in Boy Scouts

38. So what is a benchmark?
A benchmark is a point whose position is known to a high degree of accuracy and is normally marked in some way

39. Unambiguous – Securities clearly delineated
Benchmark Criteria
Unambiguous – Securities clearly delineated
Investable – Option of passive or active mgt
Measurable – Calculable on a frequent basis
Appropriate – Consistent with managers style
Opinion Reflective – Mgr has opinion of benchmark securities
Specified in advance – Constructed before use
Source: Benchmark Portfolios and
the Manager/Plan Sponsor Relationship,”Jeffery
Bailey, Thomas Richards and David Tierney

40. Sources of PE Benchmarks
PE Fund/Portfolio
PE Industry
Public Markets
Source; Alignment Capital

41. Sources of PE Benchmarks
PE Fund/Portfolio
PE Industry A
Source; Alignment Capital

42. Sources of PE Benchmarks
PE Fund/Portfolio B
Public Markets
Source; Alignment Capital

43. Sources of PE Benchmarks
PE Industry C
Public Markets
Source; Alignment Capital

44. Sources of PE Benchmarks
PE Fund/Portfolio
PE Industry D
Public Markets
Source; Alignment Capital

45. Sources of PE Benchmarks
PE Fund/Portfolio
PE Industry D B C
Public Markets
Source; Alignment Capital

46. Question: How do we benchmark?
Choosing Benchmarks
Question: How do we benchmark?
Answer: Depends on the Decision you are trying to evaluate?

47. Decisions, Decisions
A benchmark should reward/penalize the decisions made under the control of the decision maker.

48. A naïve manager would invest 50% in A and 50% in B
Naïve Manager Example
I have a choice to invest in either investment A or investment B in any amount
A naïve manager would invest 50% in A and 50% in B
Any decision that I make should be compared to the above decision and should be superior if I’m to be rewarded for my decision making.

49. Decision/Benchmark Example
I invest in vintage years 1999, 2006, 2008
Do I compare my returns to all funds in just those three years?
Do I compare my returns to all funds between 1999 and 2008?
Do I compare my returns to all funds between 1999 and present?
These scenarios benchmark different decisions primarily based on opportunity cost

50. LP has control over which managers to pick
Who has control?
LP has control over which managers to pick
LP has control over the amount / when to commit
GP has control over capital calls, exits, distributions
IRR rewards/penalizes timing
TWR is timing agnostic

51. Decisions an LP controls
The fund(s) you choose? – Manager Selection
When you committed? - Timing
The amount you invested? Pacing/Timing
Secondary Sales

52. Do PE Benchmarks Fit Criteria
A (PE-IND)
B (PE-PUB)
C (IND-PUB
D (PE-IND-PUB)
Unambiguous N Y
Investable
Measureable
Appropriate
Opinion Reflective
Specified in Advance

53. Comparing public / private equity
IRRs and TWR are incommensurable
Reinvestment rate assumption
IRR – timing matters, TWR – timing doesn’t
Public Equity/Private equity have different valuation schema
Public equity has a contemporaneous price
Private equity is an appraisal asset with significantly lagged values
So how does and investor compare public/private equity
Enter the Public Market Equivalent

54. Public Market Equivalents (PME)
Rather than calculate TWR for public equity, create a synthetic IRR for public equities
First formulation independently developed by:
Coller / Reyes (investor/researcher) in 1993 (Public Market Equivalent or PME)
Long / Nickles(alignment capital) in 1996 (called ICM “index comparison method)
Bannock/BVCA (industry association) in 1994 (called comparators)
Idea is to invest the cashflows from private equity into an index and then create a synthetic cashflow from that investment and calculate and IRR which can be compared to the original IRR
When it works, it works great, but does create some mathematical dominance stability issues under certain circumstances

55. Public Market Equivalent History
Original PME developed independently by Reyes/Coller Long/Nickles, Bannock/BVCA/EVCA ( )
Long and Nickels created an Adjusted ICM to deal with negative NAV (1998)
Roubinez and Kubr (investment managers) patented a PME method called PME+ which tries to remediate the stability issue (2003)
Kaplan and Schoar (academic researchers) created another method which isn’t a return but is a multiple (2005)
Recently, Cambridge Associates created mPME to further address stability issues (2013)
New “Direct Alpha” method developed by researchers at Landmark Partners tries to address some of the issues of the original PME while providing a direct comparison that doesn’t need an intermediate step (2014)
Global Endowment Foundation independently created same formula as Direct Alpha (2014)
Bison has created a version of PME as well. (2015)

56. Original PME/ICM/Comparators
Developed by Reyes/Coller then Long/Nickles and then Bannock/EVCA
A) Invest all capital calls into an index – compound as a positive value forward from date of capital call to the end date being measured
B) Divest all distributions from the index – compound as negative value forward from date of distribution to end date being measured
C) sum A and B to get a synthetic NAV
D) create cashflow series using original fund cashflows with their natural signs Capital calls negative and distributions positive and use the synthetic NAV in C as the terminal cashflow
E) calculate IRR on the cashflow in D
F) This is the return to the public market if you invested cashflows in the public market – can be compared to fund IRR

57. Trouble with Original PME
Under certain conditions:
Incalculable
Negative NAV when PE outperforms substantially
Long/Nickles tried to address
Capital dynamics created version ot PME which they patented which scales the cashflows to address the problem.
Cambridge Associates mPME and Direct Alpha try to address the same

58. Scales the cashflows in a variety of methods
Capital Dynamics PME+
Patented method developed by Capital Dynamics see patent number US Method and System for Benchmarking and Modeling Private Equity and Applications of Same
Scales the cashflows in a variety of methods
Takes concept of long/nickles by investing/divesting but compounds capital calls/distributions separately and then creates a ratio from those two series that is applied to the original cashflows so that the NAV never becomes negative – this is one application of their patent.
Then takes the scaled cashflows and calculates an IRR that can be compared to original fund IRR

59. Kaplan & Schoar PME
Formulated by Steven Kaplan (Univ chicago) and Antoinette Schoar (MIT) as a byproduct of a paper on private equity returns persistence
A) Invest capital calls into an index by compounding them as positive values from the date of the capital call until the end date being measured
B) Divest distributions into an index by compounding them as positive values from the date of the distribution until the end date being measured
C)Sum up A and B separately
D) add B to the original fund NAV and divide by A
E) creates a scaleless ratio – greater than 1, PE dominates, less than 1, PE underperforms public market.
F) can’t be compared to original fund but could be said to be the total return alpha to the fund over the life of the investment

60. Direct Alpha
Created by Landmark Partners and academics working with Landmark Partners
Uses concepts from original PME but the result is the direct alpha difference between the private equity fund and the public markets
A) Invest all capital calls into an index – compound as a positive value forward from date of capital call to the end date being measured. Date this synthetic cashflow result on the date of the capital call
B) Divest all distributions from the index – compound as negative value forward from date of distribution to end date being measured. Date this synthetic cahflow result on the date of the distribution
D) create cashflow series using synthetic cashflows created in A and B and combine with original fund NAV. distributions positive and use the synthetic NAV in C as the terminal cashflow
E) calculate IRR on the cashflow in D
F) This is the difference between the fund cashflows and the public markets. The comparison to the original fund is done automatically.

61. mPME Created by Cambridge Associates
Like PME+, scales cashflows so you never distribute more than you have
A) calculate a distribution weight for each distribution based on current NAV
B) compute a theoretical NAV using the the distribution weight
D) create a distribution weighted cashflow by using the distribution weight and the public market index
E) create a cashflow using the original capital calls and the weighted distributions
F) calculate IRR on the cashflow in E
G) Unlike the other methods, needs quarterly NAVs and calculates the weighted cashflows for each period rather than over the life of the fund.
Cambridge Associates and Capital Dynamics were involved in a patent infringement lawsuite of the use of scaling distributions.

62. Bison PME Created by Bison – a PE benchmarks provider
Makes the assumption that size of cashflows are as important as timing so tries to incorporate a version of the TVPI.
Scales cashflows using the equivalent of the Kaplan & Schoar ratio. The original version is more complicated, but ultimately decomposes to this simplifying method
A) calculate a K&S for the fund
B) Scale the distributions by the K&S – ultimately this is a version of capital dynamics pME+ as lambda in PME+ is 1/K&S
D) create a cashflow stream using original capital calls and scaled distributions
E) calculate IRR on the cashflow in D

63. GEM Implied Performance Premium
Created by Global Endowment management
Thought experiment: what premium would I have to add to a public market return to equalize the FV of contributions to the FV of distributions and NAV.
Equivalent to Direct Alpha and developed independently about the same time except.
Direct Alpha assumes geometric difference. IPP assumes arithmetic difference.
Direct Alpha has a closed form solution, IPP requires iterative estimation like an IRR

64. Later versions use scaling to minimize math problems
Problem with PME
Early version have mathematical stability problems under certain common conditions
Later versions use scaling to minimize math problems
But all suffer from:
Comparison of public markets to private markets not the other way around
Hard to put into investor presentations upstream to management as you can’t eaily compare to other asset classes
Mimics equivalent decision making in public markets but that may be an artificial decision making framework.
Ignores commitment and dry powder problem
Benchmarks GP decisions not LP decisions

65. Benchmarks for LPs
may be different than
Benchmarks for GPs

66. Benchmarking LP Portfolios
LPs make the following decisions
How much to commit
When to commit
Who to commit to
Cashflows afterwards are out of LPs control so benchmarks should reflect that lack of decision control.

67. Heresy: Maybe IRRs shouldn’t be used for LP portfolios

68. Heresy: Maybe we get rid of vintage year

69. Heresy: Maybe we benchmark returns on committed capital

70. How should we benchmark LPS?
Maybe we should benchmark commitment opportunity cost
Maybe calculate return on commitment in addition to return on paid-in
Benchmark from date of commitment rather than date of cashflows?
Use wealth creation on commitment compared to wealth creation of industry and public markets
Shudder -- Maybe use time weighted returns on LP Portfolios

71. Things our Current Benchmarks Framework Ignore
At Our Peril

72. Manager Selection Risk Wealth Creation Attribution
Things We Ignore
Risk Risk Risk
Temporal Allocation
Manager Selection Risk
Wealth Creation
Attribution
Excess Returns Analysis
Tracking Error