Performance Evaluation of a PE Fund

Analysis of IRR

The IRR, a cash-flow-weighted rate of return, is considered the most suitable measure of private equity performance by the Global Investment Performance Standards (GIPS), Venture Capital and Private Equity Valuation Principles, and other venture capital and private equity standards.

It’s equally important to distinguish between gross IRR and the net IRR as follows:

Gross IRR

Gross IRR replicates the fund’s ability to generate a return from portfolio firms. It is the applicable determinant for the cash flows between the fund and portfolio firms.

Net IRR

Net IRR is the net of management fees, carried interest, and other compensation to the GP. It is the applicable determinant for the cash flows between the fund and LPs and it is, therefore, the relevant return metric for the LPs.

Multiples

Multiples are equally used in the valuation of fund performance. They are a popular LPs tool due to their simplicity, ease of use, and ability to differentiate between realized and unrealized returns. They, however, ignore the time value of money.

The multiples used most frequently by LPs and also defined by GIPS that provide additional information about private equity funds performance are as follows:

PIC (Paid-in Capital)

Refers to the capital utilized by the GP and can be summarized in a formula as follows:

$$\text{PIC}=\frac{\text{Paid-in-capital to date}}{\text{Capital committed}}$$

Subsequently, it can be indicated in absolute terms as the cumulative capital utilized or called down.

DPI (Distributed to Paid-in Capital)

It measures the LP’s realized return and is summarized in a formula as follows:

$$\text{DPI}=\frac{\text{Cumulative distributions paid to the LPs}}{\text{Cumulative capital invested}}$$

It is the outcome after deducting management fees and carried interest and is also referred to as the cash-on-cash return.

RVPI (Residual Value to Paid-in Capital)

It measures the LP’s unrealized return and is summarized in a formula as follows:

$$\text{RVPI}=\frac{\text{Value of LP’ s holdings in the fund}}{\text{Cumulative capital invested}}$$

It is the resulting amount after deducting management fees and carrying interest.

TVPI (Total Value to Paid-in Capital)

It measures the LP’s realized and unrealized return and is summarized in a formula as follows:

$$\text{TVPI}=\text{DPI}+\text{RVPI}$$

It is the resulting figure after deduction of management fees and carried interest.

Investors should also scrutinize qualitative characteristics of the fund as follows:

1. The realized investments, with an assessment of expected achievements and or disappointments.
2. The unrealized investments, with an assessment of exit prospects and possible difficulties.
3. Both the cash flow projections at the fund and portfolio firm level.
4. Fund valuation, NAV, and financial statements.

The comparisons of private equity investments can be challenging since private equity funds vary considerably from one to another. Before performance evaluation is conducted, an investor should understand the fund’s structures, terms, valuation, and due diligence results. Since there are recurring tendencies in IRR earnings, the Net IRR should be compared to a similar group of comparable private equity funds of the same stature and strategy.

It is also important to note that the private equity IRR is cash flow weighted while most other asset class index returns are time-weighted. To solve this problem, we have to convert publicly traded equity benchmark returns to cash-weighted earnings and the cash flow patterns of private equity funds.

Example: Comparing the Financial Performance of Private Equity Funds

An investor is considering the following two private equity funds, Fund X and Fund Y.

$$\small{\begin{array}{l|c|c} \textbf{} & \textbf{Fund X} & \textbf{Fund Y} \\ \hline \textbf{Gross IRR} &24.2\text{%} &3.6\text{%} \\ \hline \textbf{Net IRR} & 19.7\text{%} & -0.2\text{%} \\ \hline\textbf{Performance Quartile} & 1&3\\ \hline\textbf{DPI}&2.53&0.18 \\ \hline \textbf{RVPI} &1.62&1.03\\ \hline \textbf{TVPI}&3.89&1.54\\ \hline\textbf{Fund Maturity}& 6\text{ years}&4 \text{ years} \end{array}}$$

Compare and narrate the financial performance of private equity Funds X and Y.

Solution

It is worth noting that in the above example, the comparison is between two funds with different maturity periods. As noted, a fund should be compared with peers of the same stature.

Examining the DPI, Fund X has distributed $2.53 in return for every dollar invested.

The RVPI indicates that it will return $1.62 as other investments are recouped.

The gross IRR of 24.2% looks appealing, and after fees, the net IRR is 19.7%.

The fund positions in the first quartile in its peer group of the same strategy and stature.

At Year 4, Fund Y is a less mature fund than Fund X.

Fund Y’s DPI is 0.18, denoting that the realized returns for the fund aren’t significant.

Unrealized earnings (RVPI) show that its investments not yet collected should provide an added earning. The low gross and net IRRs depict that the company could still be affected by the J-curve, where a fund experiences early losses before experiencing later profits. Currently, the firm is lagging behind its peers, as it ranks in the third quartile.

Question

Which of the following measures only the limited partner’s unrealized return in a private equity fund?

1. The TVPI.
2. The DPI.
3. The RVPI.

Solution

The correct answer is C.

The RVPI (residual value to paid-in capital) determines the LP’s unrealized return in a private equity fund. The formula denotes it:

$$\text{RVPI}=\frac{\text{Value of LP’ s holdings in the fund}}{\text{Cumulative capital invested}}$$

It is the resulting amount after deducting management fees and carrying interest.

B is incorrect. The DPI (Distributed to paid-in capital) indicates the LP’s realized return.

A is incorrect. TVPI (Total value to paid-in capital) indicates both the LP’s realized and unrealized return.

Reading 38: Private Equity Investments

LOS 38 (h) Interpret and compare financial performance of private equity funds from the perspective of an investor.