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Understanding Public Market Equivalent (PME) in Venture Capital

Public Market Equivalent (PME) has emerged as a crucial metric in venture capital performance analysis, offering investors a sophisticated way to compare private market investments against public market benchmarks. This article explores the concept, methodology, and practical applications of PME in venture capital evaluation.



What is Public Market Equivalent?

Public Market Equivalent is a performance measurement tool that helps investors evaluate private market investments by comparing them to what they could have earned if they had invested the same cash flows in a public market index. Unlike traditional metrics like Internal Rate of Return (IRR) or Total Value to Paid-In (TVPI), PME provides a relative measure that accounts for market conditions and timing of cash flows.


Key PME Methodologies

Kaplan-Schoar PME (KS-PME): The most widely adopted PME methodology, developed by Steven Kaplan and Antoinette Schoar, calculates the ratio of discounted distributions to discounted contributions, using public market returns as the discount rate.


Example: Consider a venture investment with the following cash flows:

  • Year 0: -$10M investment

  • Year 2: $2M distribution

  • Year 4: $20M final distribution


If the public market index returned:

  • Years 0-2: 20% cumulative

  • Years 2-4: 15% cumulative


The KS-PME calculation would be: KS-PME = [2M/(1.2) + 20M/(1.2 * 1.15)] / [10M]

If the result is greater than 1.0, the VC investment outperformed the public market index.


Modified PME (mPME): Modified PME simulates an equivalent investment in the public markets by:

  • Investing capital calls in the index

  • Selling index shares when distributions occur

  • Comparing final values


Example: Using the same cash flows:

  • $10M initial investment buys $10M of index shares

  • At Year 2, $2M worth of shares are sold

  • At Year 4, remaining shares are sold and compared to the $20M distribution


Practical Applications

Portfolio Evaluation: PME helps Limited Partners (LPs) assess whether their VC investments are delivering adequate returns compared to simpler, more liquid alternatives.


Example: An LP comparing two funds:

  • Fund A: IRR of 25%, PME of 1.3

  • Fund B: IRR of 20%, PME of 1.5


Despite Fund A's higher IRR, Fund B provided better performance relative to public market alternatives during its investment period.


Vintage Year Analysis: PME is particularly valuable for comparing funds across different vintage years, as it accounts for varying market conditions.


Example: Comparing two funds from different vintages:

  • 2008 Fund: IRR 15%, PME 1.4 (during market recovery)

  • 2015 Fund: IRR 20%, PME 1.1 (during bull market)


The 2008 fund, despite lower absolute returns, showed stronger relative performance given market conditions.


Advantages and Limitations

Advantages:


  • Market-adjusted performance measurement

  • Accounts for timing of cash flows

  • Enables cross-vintage comparisons

  • More relevant for institutional investors with public market alternatives


Limitations:


  • Choice of benchmark can significantly impact results

  • Assumes reinvestment at benchmark returns

  • May not capture illiquidity premium

  • Complexity in calculation and interpretation


Best Practices for Using PME

Benchmark Selection: Choose relevant indices based on:

  • Investment strategy (early-stage vs. growth)

  • Geographic focus

  • Sector concentration


Multiple Metrics: Use PME alongside traditional metrics:


Regular Updates: Calculate PME quarterly to track relative performance throughout the fund's life.


Public Market Equivalent has become an essential tool in venture capital performance analysis, offering a more nuanced view of returns compared to traditional metrics. While not perfect, PME provides valuable insights for institutional investors making allocation decisions between private and public markets. The growing sophistication of PME methodologies and their widespread adoption by institutional investors underscores the importance of understanding and properly implementing this metric in venture capital performance assessment.

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