Benchmarking Private Equity: The Direct Alpha Method

Abstract

We reconcile the major approaches in the literature to benchmark cash flow-based returns of private equity investments against public markets, a.k.a. 'Public Market Equivalent' methods. We show that the existing methods to calculate annualized excess returns are heuristic in nature, and propose an advanced approach, the 'Direct Alpha' method, to derive the precise rate of excess return between the cash flows of illiquid assets and the time series of returns of a reference benchmark. Using real-world fund cash flow data, we finally compare the major PME approaches against Direct Alpha to gauge their level of noise and bias.

Keywords: Illiquid assets, excess return, modern portfolio theory

JEL Classification: G11, G12, G23, G24