Private equity continues to be a rapidly growing asset class as investors seek ways to diversify and dampen their portfolios against market volatility. As with all investments, questions regarding past performance arise when deciding whether or not to include private equity within the overall asset allocation of a portfolio. While private equity investing is not a purely scientific process, private equity performance metrics serve a crucial purpose by providing quantifiable benchmarks and comparative data. Unfortunately, both managers and LPs often use diverse and inconsistent approaches when calculating historical returns. These fragmented data points, coupled with irregular cash flows that distinguish private equity from other asset classes, contribute to much of the ambiguity surrounding performance measurement today.
This article is designed to clarify these ambiguities by introducing some of the commonly used metrics and assessing the advantages and limitations of each when evaluating prihttps://blog.darcmatter.com/wp-admin/plugins.phpvate equity performance.
IRR
The internal rate of return (IRR) is the metric commonly used to measure private equity performance. IRR measures the discount rate that makes the net present value of a series of cash flows equal zero; simply put, it is the annual yield on an investment of the underlying cash flows. The advantage of this approach is that it takes into consideration the time value of money as well as irregular cash flows that mark private equity.
Despite its nearly ubiquitous use, IRR has become an increasingly controversial performance metric because of certain methodological biases that skew performance. For one, it assumes cash flows are reinvested at the same rate of return, which is most often not the case. When the IRR is higher than the actual reinvestment rate, this can result in an artificially boosted portrayal of performance. As such, IRR places significant weight on a fund’s early returns, which can disproportionately inflate the fund’s IRR and make it appear as if a fund’s early, outsized returns were generated consistently throughout its term. In reality, it is not always the case that a fund will have readily available and equally profitable prospects in which to invest distributions.
MIRR
To address some of the shortcomings of IRR, some have adopted and developed a modified version of the IRR, or MIRR (modified IRR). This method does not assume that returns are reinvested at the same rate of return and instead uses an assumed reinvestment rate that is usually lower than the return of the investment. This potentially mitigates the risk of presenting overly optimistic returns.
Having said that, the final calculation of MIRR hinges on the assumed reinvestment rate. MIRR also assumes that a fund continues after the final cash flow distribution, which means that the final return estimate can be biased towards the investment rate that is assumed.
Multiples
Multiples measure returns from an investment by dividing the value of the returns by the amount of money invested. Two common versions are 1) distributions to paid in capital (DPI), and 2) total value to paid in capital (TVPI). The DPI is the ratio of money distributed by the fund against the money invested in the fund. The TVPI measures the ratio of a fund’s cumulative distributions and residual value against paid in capital; it takes into account what return would result if unrealized assets were sold at current valuations and added to already paid out distributions. TVPI provides a more comprehensive understanding of returns, but suffers from uncertainties regarding the valuations placed on unrealized investments. Despite this, both are relatively simple calculations that provide a simple way to view the performance of a fund and its investments.
However, unlike IRR, multiples do not take into account the time value of money. For example, an investment that is able to produce a 5x multiple in 2 years would be more attractive than one that can do the same in 10 years. In very much the same way, multiples do not reflect the scale or size of absolute returns, which is rather important when comparing the performance of two different investments. A relatively small investment with a 5x multiple, for example, would not necessarily produce higher returns on an absolute basis than a large investment with a 2x return.
Adopting a Holistic Approach
There are obviously numerous limitations when using each of the above methods in isolation when it comes to measuring private equity performance. While there is no single magic bullet for comprehensively and accurately assessing the performance of a private equity fund, these data points can still be employed to get a better, quantitatively driven understanding of a fund. It is important to note that investors should not overlook the importance of inspecting qualitative elements of the fund such as the management team’s industry, financial engineering, and operational expertise in conjunction with performance metrics. There is much to be said for this qualitative approach, as there are many intangible factors that can significantly impact the investment decision-making process.
—
“NO FINANCIAL ADVICE – The information on this article is provided for educational and informational purposes only, without any express or implied warranty of any kind, including warranties of accuracy or completeness for any particular purpose. The information contained in this article is not intended to be and does not constitute financial advice, investment advice, trading advice or any other advice.
You should not make any decision, financial, investment, trading or otherwise, based on any of the information presented without undertaking independent due diligence and consultation with a professional broker or competent financial advisor. You understand that you are using any and all information available on or through this website at your own risk.”
DarcMatter (“DM”) is a global fintech platform that streamlines the capital raising process for asset managers and provides investors with transparent and direct access to funds in the asset management industry.
DM’s mission is to enhance capital flow through fintech to create transparency and efficiency by providing direct access to funds in the Asset Management industry for Accredited Investors, Advisors, and Asset Managers.
