Taking the measure of private equity

The private-equity industry has undergone a significant mindset shift with regard to reporting of returns. As traditional exit routes remain gridlocked and liquidity scarce, investors unable to turn portfolio returns into cash are rethinking what successful performance looks like. The competition for capital and investor demand for liquidity has put pressure on traditional metrics, including those factoring in unrealized valuation components, such as internal rate of return. That’s resulted in investors asking for a broader range of measurements to triangulate data when making decisions on where to allocate capital.

Absolute metrics

• Internal rate of return (IRR) For many years, the IRR was the industry’s default measure of performance in a world in which cash was inexpensive and exit routes were generally open. In recent years, this has not been the case. The growing disconnect between buyers and sellers means that what a portfolio might be worth on paper often does not come to pass in the market. When evaluating performance, investors increasingly want to know whether these assets can be realized at the current valuation. This is a question IRR alone cannot answer. As a result, many are no longer willing to accept it as the main measure of a fund’s success.
• Distribution to Paid-In (DPI) Investors also want to know what “real” money a stake in private equity has returned to them. The DPI capital ratio, which measures actual cash returns relative to the invested capital, has become an increasingly significant metric for investors. While IRR measures the annualized rate of return on invested capital, DPI provides a snapshot of the actual returns to investors. It factors in cashflows and their timing. But this metric also considers unrealized valuations, inserting subjectivity based on the forecast element.
• Total Value to Paid-In (TVPI) This is a point-in-time calculation that considers both realized investment distributions and unrealized portfolio valuations. It represents the total value of a fund relative to the amount of capital paid into the fund to date, though it does not factor in the time value of money. The objective is to converge the TVPI into DPI over time by monitoring the trend of the IRR and TVPI progression relative to the DPI. That is where paper valuations are translated to real returns. Private-equity fund managers generally look for DPI to exceed 1x in the first instance, indicating 100% of return of investor capital, followed by a DPI of 1.4x, suggesting a fund is near to or is paying carried interest. At this juncture, investors should have also received their preferred return in cash. 
• Multiple of Invested Cost (MOIC) This measure can be applied at the fund or asset level, gross or net. This is a simple calculation for assessing the return on an investment without the time value of money component. The numerator is the sum of the realized and unrealized value; the denominator is the sum of invested capital. But opinions vary about whether expenses should be included, giving rise to different approaches. Such inconsistencies in practice lead to difficulties in comparing MOICs when assessing fund performance.

Relative metrics

• Public Market Equivalent (PME) and Index Comparison Method (ICM) This is a methodology designed to compare performance of a fund against a public market benchmark. Although it is well known, it has inherent limitations. The first comes with selecting an index with re-investment (mimicking investor drawdowns and distributions). Another is the challenge of identifying an index with risk/returns similar to those of private-equity strategies. Lastly, finding a mathematical method that mimics the private fund buying and selling the model portfolio is difficult. The PME/ICM method dates to the late 1990s. Analysts create a model portfolio mimicking the cash flows of the private equity fund, creating a reference valuation had the investment been made in a public market. This provides a basis for assessment of the relative performance of the IRR. However, this methodology does not realize the model portfolio at the same pace as the private equity fund. It is possible for outperforming funds to take a short position in the model portfolio, a critical shortfall of the underlying methodology. PME+ addresses this by applying a scaling factor to the distributions so that the model portfolio liquidates at the same time as the fund. Industry adoption of PME benchmarking has been increasing, alongside traditional private equity measures. 
• Direct Alpha Performance As alpha generation is the objective of investing in private equity and a predominant factor in investors' decision-making when allocating capital, the Direct Alpha Performance methodology is an IRR calculation using the cashflows from the private equity fund which are being discounted by the returns of the reference benchmark.
• Time Weighted Returns (TWR) Public fund investors attempt to recalculate private equity fund performance by computing their own TWR using the cashflows and capital account statements provided; they do this as they do not control cash flowing into and out of their pension fund and as this allows assessment against public market securities.

Ultimately, investors will use a range of measures to assess performance and select those which are most relevant to their capital allocation. In response, private equity managers will (and do) provide a range of measures to benchmark their own performance to help investors.

Of the above, DPI is rising in prominence, though Federated Hermes has employed it for years. We believe success is best demonstrated by seeking to deliver consistent real — rather than paper — returns, and DPI has been the key metric we use to communicate this focus to investors. The heightened interest in DPI is a welcome return to private equity’s core purpose as an asset class: pursuing alpha by aligning general partner (GP) and limited partner (LP) expectations through the measure of real cash-on-cash return.

This commentary was first published in The Drawdown.