Private equity operates a bit differently than public markets, which can make measuring investment success a complex but essential task. Investors and fund managers rely on various performance metrics to evaluate returns, assess the skills of fund managers, and determine how effectively they allocate capital. Understanding these metrics is crucial for making informed investment decisions and gauging a fund’s potential success.
We will dive into five commonly used metrics in private equity performance evaluation: Internal Rate of Return (IRR), Total Value to Paid In (TVPI), Distributed to Paid-In (DPI), Multiple on Invested Capital (MOIC), and Public Market Equivalent (PME). While these metrics are widely used, they are not the only tools in the industry. Let us explore what each of these key metrics reveals about investment performance, along with their strengths and limitations.
1. Internal Rate of Return (IRR) – The Time-Weighted Growth Engine
IRR is a fundamental metric in private equity. It represents the annualized effective compounded return rate of an investment over its entire lifespan. In simple terms, IRR is the rate at which the present value of expected future cash inflows equals the initial investment. This makes it a vital tool for evaluating how well an investment performs.
What IRR Reveals
IRR serves several purposes in investment analysis. Generally, a higher IRR indicates a more profitable investment and allows for easy comparison of potential returns across different opportunities. Companies often use IRR to decide whether to pursue a new project or investment by comparing it to their required rate of return or cost of capital.
Pros of IRR
・Time Sensitivity: It captures the timing of cash flows, which is crucial for investment efficiency.
・Comparability: IRR allows for direct comparisons across different investment horizons and asset classes.
・Widely Understood: It is a standard metric in finance, making it accessible to most investors.
Cons of IRR
・Sensitivity to Interim Valuations: For illiquid assets, interim valuations can distort true long-term performance.
・Reinvestment Rate Assumption: IRR assumes that interim cash flows can be reinvested at the same rate, which is not always realistic.
・Multiple IRRs: Uneven cash flows can lead to multiple IRRs, complicating interpretation.
・Doesn’t Reflect Absolute Size of Return: A high IRR on a small investment may be less impactful than a lower IRR on a larger investment.
2. Total Value to Paid In (TVPI) – The Comprehensive Value Indicator
TVPI is a straightforward metric that measures the total value a fund has generated for its investors. It considers both realized profits (the cash returned) and unrealized potential profits (the current estimated value) compared to the initial investment. Essentially, it answers: “What is my total return on investment so far, including cash and estimated value?”
Since investors in venture funds often cannot easily cash out, TVPI includes future potential returns until the fund is fully liquidated. After liquidation, the focus shifts to DPI, which measures the actual cash returned to investors.
What TVPI Reveals
A TVPI of 1.0x means that investors have recovered their initial investment, while values above 1.0x indicate profits. This metric helps investors gauge current performance and assess future growth opportunities, making it a valuable tool for performance evaluation.
Pros of TVPI
・Comprehensive View: It includes both cash returned and the estimated value of remaining investments.
・Useful Throughout Fund Lifecycle: TVPI offers insights into overall value creation, even in the early stages of a fund.
・Indicates Future Returns: The unrealized portion hints at potential future gains.
Cons of TVPI
・Includes Unrealized Value: Subjective valuations can create discrepancies in what is ultimately realized.
・Ignores Time Value of Money: Like DPI, TVPI does not account for the timing of cash flows.
・Influenced by Market Sentiment: Unrealized investments can be affected by market conditions, which might skew perceived value.
3. Distributed to Paid-In (DPI) – A Reality Check on Cash Returns
The Distributed to Paid-In (DPI) ratio focuses on tangible returns. It is calculated by dividing the total cash distributed to investors by the total capital they have contributed. DPI matters because it reflects actual returns on capital after accounting for fees and expenses. Once a fund has liquidated all its holdings and distributed the proceeds, DPI represents the value investors have received.
What DPI Reveals
DPI figures can vary widely across different funds and throughout a fund’s lifecycle. What’s considered a “good” DPI can also shift with market conditions. Essentially, DPI gives a clear view of actual cash returned to investors. A DPI of 1.0x means investors have received back their initial investment, while a DPI above 1.0x signifies profit.
Pros of DPI
・Focus on Realized Returns: DPI emphasizes cash flowing back to investors, crucial for liquidity.
・Transparency: It provides a straightforward measure of tangible returns.
・Relevance in Volatile Markets: In uncertain times, realized returns become more important, making DPI a key indicator of success.
Cons of DPI
・Ignores Unrealized Value: Unlike TVPI, DPI doesn’t account for potential future returns from remaining investments. It’s often considered alongside RVPI and TVPI for a fuller picture.
・No Time Value of Money: DPI does not account for when distributions occur, overlooking factors like inflation and reinvestment opportunities.
・May Understate Long-Term Potential: Early in a fund’s life, DPI can be low because the focus is more on investing than returning capital, which may not fully capture overall performance compared to TVPI.
4. Multiple on Invested Capital (MOIC) – The Total Return Multiplier
The Multiple on Invested Capital (MOIC) measures the total return generated by an investment relative to the initial capital contributed. It is a simple ratio calculated by dividing the total gross distributions received, plus the current value of any remaining holdings, by the total capital invested.
What MOIC Reveals
MOIC provides a clear indication of the total value created for every dollar put into the investment. For example, a MOIC of 1.5x means that for each dollar invested, the fund has generated $1.50 in value, including both cash returned and the current worth of its remaining assets.
Pros of MOIC
・Simplicity: MOIC is easy to calculate and understand, giving a quick snapshot of overall returns.
・Focus on Absolute Returns: It highlights the total multiple of the initial investment achieved, regardless of duration.
・Useful for Individual Investments: MOIC is especially valuable for assessing the success of specific portfolio companies upon exit or at a specific valuation point.
・Includes Unrealized Value: MOIC factors in the current estimated value of remaining investments, offering a more complete picture of potential.
Cons of MOIC
・Ignores Time Value of Money: MOIC does not account for how long it took to generate returns. A 2.0x MOIC over ten years is less impressive than the same multiple in five years.
・Includes Unrealized Value: The portion attributed to unrealized investments is based on estimations and can fluctuate with market conditions.
・Lacks Insight on Cash Flow Timing: MOIC does not reveal when investors actually received cash distributions, which is important for liquidity and reinvestment.
Comparison Against DPI
While MOIC and DPI both relate to invested capital, they offer different perspectives. MOIC represents total value created (realized and unrealized) as a multiple of invested capital. It answers, “For every dollar invested, what is the total current value I have, both in hand and in remaining assets?” On the other hand, DPI focuses solely on realized returns, showing how much cash has actually been returned to investors.
Thus, MOIC provides a broader view of a fund’s potential at a specific time, while DPI offers a more concrete measure of cash returned to investors. A fund might have a high MOIC driven by significant unrealized gains but a lower DPI if exits have been limited. Conversely, a fund with strong early exits might show a high DPI, even if the remaining portfolio value (and thus MOIC) is less substantial. Investors often look at both metrics to understand the complete performance story: the total value being created (MOIC) and the tangible cash being returned (DPI).
5. Public Market Equivalent (PME) – Benchmarking Against the Public Arena
The Public Market Equivalent (PME) is a valuable tool for comparing a private equity fund’s performance to a relevant public market index. PME simulates what would have happened if the same cash flows had been invested in a public index, allowing for a direct comparison of returns.
What PME Reveals
PME provides an important external benchmark, showing how capital committed to a private equity fund might have performed if invested in publicly traded securities. This helps investors assess the value added by the fund manager and understand whether their performance justifies the investment.
Pros of PME
・External Benchmark: PME offers a useful comparison against a liquid and transparent market, making performance assessment easier.
・Assesses Manager Skill: It shows whether the fund manager can outperform the broader market, highlighting their effectiveness.
・Accounts for Timing of Cash Flows: By reflecting actual cash flow patterns, PME provides a relevant comparison that considers when investments are made.
Cons of PME
・Index Sensitivity: PME results can vary significantly based on the chosen benchmark, which can be somewhat subjective.
・Assumes Perfect Liquidity: Public indices don’t factor in the illiquidity and costs associated with private equity investments.
・Risk Profile Differences: Private equity investments often involve different risks than public market indices, which can affect comparisons.
・Methodological Complexity: Different approaches to calculating PME can lead to varying results, adding complexity to the analysis.
