Bridging the Gap: Comparing Public and Private Market Investment Performance

In today's investment landscape, the lines between public and private markets are becoming less defined. As companies and investment vehicles move more freely between these two realms, it's critical for investors to have reliable methods to compare their performance. Traditionally, public market returns are measured with time-weighted returns (TWR), while private market results lean heavily on internal rate of return (IRR) and multiples of invested capital. Unfortunately, these different metrics don’t always play well together, making apples-to-apples comparisons difficult.

This blog aims to shed light on proven approaches for harmonizing performance measurement. By applying these methods, you can more confidently evaluate both public and private opportunities on a level playing field.

Key Performance Metrics: Public vs. Private Markets

Public Markets: Time-Weighted Returns (TWR)

Public market vehicles—like stocks, ETFs, or mutual funds—are typically liquid and marked to market daily. Because capital can move in or out at any time, time-weighted returns (TWR) remove the effects of those external cash flows, focusing instead on the manager's skill in growing capital.

Why It Matters: TWR is ideal for situations where the investor isn’t dictating when the money is put to work. If you’re evaluating, say, a large-cap equity fund manager, TWR tells you how effectively they grew your money given the market environment.

TWR = (Product of (1 + R_i) over each sub-period) – 1

Private Markets: Internal Rate of Return (IRR) and Multiples

In private equity, venture capital, or real estate deals, capital calls and distributions can happen at irregular intervals. The internal rate of return (IRR) takes this cash-flow timing into account, making it a natural fit for longer-term, illiquid assets. Multiples, like MOIC (multiple on invested capital) or DPI (distributions to paid-in), further clarify how much money you actually get back compared to what you put in.

IRR Caveat: IRR can look artificially high if a small distribution arrives early in the fund's life. When comparing different private funds, or when you’re stacking them up against public market returns, keep an eye on these nuances.

Σ [CF_t / (1 + IRR)^t ] = 0

Challenges in Comparing Public and Private Market Performance

1. Liquidity and Valuation Frequency
   • Public markets reprice daily, offering immediate liquidity.
   • Private markets rely on quarterly or annual valuations, with limited exit options.
2. Cash Flow Timing
   • IRR is sensitive to the specific timing of calls and distributions.
   • TWR ignores cash flow timing altogether.
3. Risk Adjustments
   • Illiquid assets often show smoothed volatility; you don’t see the full spectrum of price swings day to day.
   • Public markets can reveal volatility in real time, but that also means more perceived risk.
4. Benchmarking
   • Public market indices (e.g., S&P 500) are broadly accepted and updated continuously.
   • Private benchmarks are often proprietary, less transparent, and can lag the market.

Approaches to Harmonize Performance Measurement

1. Converting Private IRRs to Public-Equivalent Returns

A popular family of methods to even out the playing field is the Public Market Equivalent (PME). PME tracks what would have happened if, instead of investing in a private fund, you had put that same money into a public index at the same points in time.

• Kaplan & Schoar PME: Produces a ratio—if it’s over 1, the private investment outperformed the index; below 1, it underperformed.
• Direct Alpha: Takes the PME concept a step further by calculating the annualized "alpha" relative to the public benchmark, effectively telling you how much extra return the private investment generated.

2. Liquidity-Adjusted Public Market Returns

To bridge the gap from the public side, some investors introduce illiquidity factors into public returns:

• Smoothing Mechanisms: Apply a lag or rolling average to replicate private-style pricing.
• Lock-Up Simulations: Impose holding periods and limit redemptions to see how a public portfolio might perform under private market constraints.
  

3. Hybrid IRR for Public Investments

If you want a direct IRR-to-IRR comparison, one tactic is to create a "private-style" cash flow schedule for a public portfolio. For example, you might simulate capital calls and distributions in an S&P 500 index fund, then measure IRR based on those hypothetical transactions.

4. Risk-Adjusted Comparisons

Comparing only returns misses a huge piece of the puzzle: risk.

• PME-Based Sharpe Ratio: Adjusts the PME approach to include volatility metrics from public indices.
• Beta Comparisons: Regress any private returns data (where available) against a public index to see how sensitive they might be to broader market moves.

The Convergence of Public and Private Markets

Private markets now manage more than $8 trillion in assets, fueled by innovative structures like secondaries, interval funds, and business development companies (BDCs) that offer semi-liquidity. Meanwhile, private companies are staying off the public exchanges longer, blurring the lines between what we consider "public" and "private."

Trends Driving Convergence

• Semi-Liquid Private Structures: Interval or evergreen funds that allow periodic redemptions.
• Public-to-Private and Private-to-Public Transactions: Companies frequently delist or list, crossing market boundaries with ease.
• Institutional Demand: Pension funds and other large players are now allocating a bigger slice to alternative investments.

Implications for Performance Measurement

• More Frequent Valuations: Regulatory changes and industry norms push for more transparency in private markets.
• Standardization Efforts: Initiatives by groups like the CFA Institute and GIPS aim to unify performance reporting across public and private domains.

Conclusion: Towards Unified Performance Assessment

In a world where the definitions of "public" and "private" are no longer set in stone, it’s more important than ever to compare these investments with a common lens. Tools like the PME framework (including Direct Alpha) and hybrid IRRs can turn disparate metrics into meaningful insights. Smoothing or simulating public returns can help gauge how a portfolio would behave under private constraints, while risk-adjusted techniques bring needed depth to the analysis.

Ultimately, understanding both returns and risk in a holistic manner leads to better decision-making. As the industry moves toward more frequent valuations and standardized reporting, we’ll continue to see improvements in how investors measure, manage, and benchmark performance across the full spectrum of public and private opportunities.