16 Session 7: PME · LA-IRR · LA-PME
| Unit | 2 — Measurement and Theory |
| Book Chapter | 4 (sections 4.5–4.10) |
| Track | Common core (both tracks) |
16.1 Learning Objectives
By the end of this session, students will be able to:
- Compute the Kaplan-Schoar PME for a given fund’s cash flows against a chosen public benchmark.
- Distinguish Kaplan-Schoar PME, Long-Nickels PME, and Direct Alpha — and state when each is appropriate.
- Articulate why all standard PME variants share the same constant-rate weakness as DCF and IRR.
- State the LA-IRR and LA-PME formulas and explain what corrections they apply.
- Apply LA-PME to a worked example and interpret the result against a standard PME.
16.2 Pre-Class Assignment
- Read: Book Chapter 4, sections 4.5–4.10 (~12 pages)
- Optional: Kaplan & Schoar (2005), “Private Equity Performance: Returns, Persistence, and Capital Flows,” Journal of Finance; Gredil, Griffiths, & Stucke (2014), “Benchmarking Private Equity: The Direct Alpha Method”
16.3 In-Class Outline (75 minutes)
| Time | Segment | Format |
|---|---|---|
| 0:00–0:05 | Recap: IRR’s problems → need a different metric | Lecture |
| 0:05–0:20 | Kaplan-Schoar PME: ratio of FVs | Lecture + numerical example |
| 0:20–0:35 | Long-Nickels PME: implicit reinvestment | Lecture + numerical example |
| 0:35–0:45 | Direct Alpha: extracting excess return rate | Lecture |
| 0:45–1:00 | LA-IRR and LA-PME: GE-LAV corrections | Lecture + math |
| 1:00–1:15 | Worked comparison + when to use which | Worked example + discussion |
16.4 Discussion Questions
- A 2009-vintage PE fund reports IRR of 22% and KS PME of 1.45. LA-IRR is 16% and LA-PME is 1.18. How should an LP allocating capital today interpret these numbers?
- The carry computation in a typical LPA uses reported IRR with an 8% preferred return. If LA-IRR becomes standard, does the 8% hurdle remain at 8%? What should it be?
- Some recent academic work argues that PE has earned zero alpha after correct adjustments (Phalippou, Stafford). Other work argues it earns positive alpha (Harris-Jenkinson-Kaplan). Where do you sit, and what’s the role of methodology choice in your answer?
16.5 Worked Numerical Example: Full LA-PME Calculation
Setup: A 2010-vintage US buyout fund.
| Year | Capital Call (\(M) | Distribution (\)M) | S&P 500 cumulative | Implied L_t | |
|---|---|---|---|---|
| 2010 | 50 | 0 | 1.00 | −0.4 |
| 2011 | 30 | 0 | 1.02 | −0.3 |
| 2012 | 20 | 0 | 1.20 | 0.0 |
| 2014 | 0 | 30 | 1.55 | +0.2 |
| 2016 | 0 | 50 | 1.65 | +0.3 |
| 2018 | 0 | 80 | 2.00 | +0.1 |
| 2020 | 0 | 25 | 1.95 | −0.5 |
| 2022 | 0 | 45 | 2.30 | −0.6 |
| 2024 | 0 | 60 | 2.70 | −0.4 |
Step 1: Standard KS PME
Numerator: \(30/1.55 + 50/1.65 + 80/2.00 + 25/1.95 + 45/2.30 + 60/2.70 = 19.4 + 30.3 + 40.0 + 12.8 + 19.6 + 22.2 = 144.3\)
Denominator: \(50/1.00 + 30/1.02 + 20/1.20 = 50 + 29.4 + 16.7 = 96.1\)
\(KS PME = 144.3 / 96.1 = 1.50\) → 50% outperformance
Step 2: Compute liquidity-adjusted benchmark \(B_t^{LA}\)
Using calibrated \(\pi(L) = 0.045 - 0.025 L + 0.021 L^2\):
At each year, compute \(\pi(L_t)\) and integrate over time. The cumulative liquidity premium drag on the benchmark over 14 years (assuming average \(\pi\) ≈ 4.5%) is approximately \(\exp(0.045 \cdot 14) = 1.88\).
Adjusted benchmark levels: \(B_t^{LA} = B_t \cdot e^{\int_0^t \pi(L_s) ds}\)
For simplicity, applying a uniform 4.5%/year drag:
| Year | Adjusted Benchmark |
|---|---|
| 2010 | 1.00 |
| 2011 | 1.067 (1.02 × 1.046) |
| 2014 | 1.79 (1.55 × 1.156) |
| 2018 | 2.66 (2.00 × 1.33) |
| 2022 | 3.45 (2.30 × 1.50) |
| 2024 | 4.21 (2.70 × 1.56) |
Step 3: Recompute PME with adjusted benchmark
Numerator: \(30/1.79 + 50/[B_{2016}^{LA}] + 80/2.66 + 25/[B_{2020}^{LA}] + 45/3.45 + 60/4.21\) ≈ \(16.8 + 24.5 + 30.1 + 9.5 + 13.0 + 14.3 = 108.2\)
Denominator: \(50/1.00 + 30/1.067 + 20/1.135 = 50 + 28.1 + 17.6 = 95.7\)
\(LA PME = 108.2 / 95.7 = 1.13\) → 13% outperformance
Interpretation: - Reported KS PME: 1.50 (50% outperformance) - LA-PME: 1.13 (13% outperformance) - 37 percentage points of reported outperformance was compensation for the liquidity premium drag the benchmark didn’t reflect
16.6 What to Expect Next Session
Session 8 is the synthesis of Unit 2: what would a correct theory of private market valuation actually require? We’ll cover the five requirements from book Chapter 5:
- Stochastic illiquidity premia
- Investor heterogeneity
- Endogenous market-clearing
- Empirical implementability
- Welfare and regulatory analysis support
GE-LAV satisfies all five. No other current framework does. Session 8 sets up the midterm and the conceptual transition to Unit 3 (decision and application).
Reading: Book Chapter 5, all sections (~10 pages — short chapter).
Reminder: PS1 is due Session 8. Allow yourself the weekend to work through the OU calibration questions.