Private equity is an alternative asset class that has the potential to produce substantial, long-term returns for investors, an upside balanced by the potential for significant risk. As an alternative asset class, it comes with distinctive features that set it apart from traditional assets like publicly traded stocks and bonds. As a result of these differences, and the lack of publicly available performance metrics, performance must be measured using different tools.
What is a Private Fund?
A private fund, whether it be a private equity fund or a venture capital fund (which is a subset of private equity), essentially pools capital from investors (limited partners, or LPs) to create an investment vehicle that the fund manager (general partner, or GP) will go on to invest across multiple companies. (If you’re interested in learning more about how private funds work, we have another blog post that goes more in-depth on that topic.) How the fund manager deploys this capital can vary, depending on if it’s a private equity fund or a venture capital fund and the overall strategy of the fund manager. Typically, these funds have 10 years to fully invest in the capital.
Important Concepts to Know
Before we jump into measurement, there are a few terms and concepts that are important to understand first.
Paid-in-capital refers to the money contributed by investors into the fund. Paid-in-capital is not the amount that has been committed, but rather, what has been “called.” Committed capital is the amount the investor has agreed to invest over the lifetime of the fund. Called capital (paid-in-capital) is what has been invested by the fund manager thus far. For example, an investor may have committed $1 million to a fund. After the first five years, maybe only $500,000 of that commitment has actually been called by the fund manager.
Gross vs. Net returns
In measuring performance, you want to look at net returns, not gross returns. Net returns are your returns minus any commissions, fund management fees, carried interest, etc. Gross returns don’t factor in these costs and can skew actual performance.
Distributions are the value of the cash and stock the fund has returned to investors. Ideally, distributions grow as a fund ages and investments are exited.
Residual value is the remaining value of the fund at a given point in time; i.e., the value of the fund’s investments plus other fund assets less fund liabilities. For example, a fund has a remaining 7 investments with an aggregate estimated value of $70 million, plus $2 million in cash. The residual value of the fund would be $72 million. Over time, if the fund is performing well, residual value will decrease, as the fund exits its investments and makes distributions to investors. It’s worth noting that residual value is just an estimate, as it’s based on the values of the underlying investments.
Total value is equal to the sum of distributions plus the remaining residual value at a given point in the fund’s life.
The primary tools used by investors to measure fund performance are rate of return, multiples, comparative return, and public market equivalent performance.
Internal Rate of Return (IRR)
IRR estimates the annual growth rate of an investment. One major advantage of using IRR over other metrics is that it takes the time value of money into account. Check out our blog on IRR to learn when to use it and how to calculate it.
There are three multiples that are widely used in measuring the performance of private funds: TVPI, DPI, and RVPI.
- TVPI – Stands for “Total Value to Paid-in-Capital.” It is the ratio of total value to paid-in-capital.
TVPI = Total Value / Paid-in Capital
- DPI – Stands for “Distributions to Paid-In-Capital.” It is the ratio of distributions to paid-in-capital.
DPI = Distributions / Paid-in-Capital
In practice, the higher this ratio is, the better. For example, a DPI of 1x would mean investors have broken even, while a DPI of 2x means the fund has returned double an investor’s paid-in -capital.
- RVPI – Stands for “Residual Value to Paid-in-Capital.” It is the ratio of residual value to paid-in-capital.
RVPI = Residual Value / Paid-in-Capital
While multiples are easy to use, they don’t take into account time value of money, and they measure interim performance, rather than final performance. Another thing to note when using multiples is that they will fluctuate over time, and are typically more “reliable” for gauging results later in the life of the fund.
Comparative Return Analysis
Comparative return analysis compares a fund’s performance to that of a similar fund. If a fund is performing in the top quartile, it means it’s performing better than at least 75% of similar funds.
In order to conduct this type of analysis, you needs statistics for comparable funds, which can be more difficult to come by for private equity investments than in the public equity universe. If you are able to access such information, you can use statistics on funds of the same age and similar strategy to compare performance metrics.
Public Market Equivalent Performance (PME)
PME compares the return of a private equity fund to return of a public stock market index. There are many variations on how to calculate PME, but for the sake of this example, we will use the Long-Nickels version.
In it, the performance of a private equity fund is compared to the S&P 500 Index by theoretically “investing” in the S&P using the private equity fund cashflow. Under this scenario, when capital is called, it’s assumed that the same amount is used to “buy” the index. Similarly, when receiving a distribution, the same amount of the index is sold, and so on and so forth. Over time, this PME will tell you how a public market investment equivalent to the private market investment would have performed.
Things to Remember
While the methods described here can be helpful in assessing private fund performance, they cannot do so in isolation, nor is there one singular way to measure performance. Individual investors would do well to remember that one metric will never tell the whole story, and these methods should be used in concert.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.
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