Key Takeaways

• Several different methodologies are used for measuring the performance of private equity funds or comparing them to public market investments.
• Internal rate of return calculations are used to accommodate the irregular cash flows in PE funds.
• Several measures address returns as a multiple of the capital paid into the fund by the investor.
• A public market equivalent methodology can be used to compare the performance of a PE fund with that of the equity market during the same time period.

To measure the investment performance of private equity funds, the industry had to address the unique characteristics of PE funds. This includes the absence of continuous market pricing and the fact that investors typically place their investments through multiple capital calls and receive their proceeds through multiple distributions.

Taking these characteristics into account, the industry uses several methodologies to measure performance, providing both flexibility and consistency while accommodating the different needs and perspectives of both investors and fund managers.

These methodologies include:

Internal Rate of Return calculations

• Internal Rate of Return (IRR)
• Modified Internal Rate of Return (MIRR)
  

Returns on Paid-in Capital

• Total Value to Paid-in Capital (TVPI)
• Residual Value to Paid-in Capital (RVPI)
• Distributions to Paid-in Capital (DPI)
• Multiple on Invested Capital(MOIC)
  

Returns compared to public market investments

• Public Market Equivalent (PME)
• Alpha

Measuring the Internal Rate of Return

Internal Rate of Return (IRR):

When cash flows in or out of an investment are irregular or uneven, the most widely accepted way to determine overall performance is to calculate the Internal Rate of Return (IRR). IRR is essentially a rate of interest that equates a series of uneven cash flows to a single lump sum invested at the beginning of the period and a single distribution at the end of the period.

To illustrate IRR, if an investor paid three capital calls of $100,000 each over 18 months into a PE fund, and ten years later received two distributions of $250,000 each, an IRR calculation would find the equivalent interest rate that would turn $300,000 into $500,000 over the time period marked by the initial investment commitment and the final distribution payment.

Modified Internal Rate of Return (MIRR):

Inherent to a standard IRR calculation is the assumption that uninvested capital (that which is committed and awaiting capital calls) or reinvested capital (from the early distributions) is also invested at the same IRR rate.

Since capital awaiting investment and capital reinvested from distributions typically yield different returns than capital in the fund itself, some people prefer to use more realistic rates for uninvested or reinvested capital, or rates that reflect specific opportunities available to them. An IRR that is calculated with customised rate inputs for uninvested or reinvested capital is called a Modified Internal Rate of Return (MIRR).

A modified IRR should more accurately reflect the returns to an investor of the total capital committed to, and derived from the PE fund. However, fund managers will typically use standard IRR calculations in order to provide a consistent number to all their investors.

Measuring the Total Return

IRR and MIRR calculations are based on the amount and timing of all cash flows associated with a PE investment. Until all cash flows have occurred, IRR cannot be meaningfully calculated. In addition, since investments in PE funds are made through multiple payments and returned through multiple distributions, investors find it helpful to measure the actual amount of capital that has been returned to them through distributions relative to the amount of capital they actually paid in and how much residual value remains in the fund.

To accommodate investors in this regard, PE funds provide several measures that focus on the actual cash-on-cash returns (net of fees) an investor has received and the approximate remaining cash value of their investment in the fund. Such measures ignore the timing of cash flows, focusing only on the amounts but they provide a way of measuring interim performance at any point in a fund’s life.

These measures are as follows:

Distributed to Paid-in Capital (DPI):

DPI measures the cumulative total of distributions received by an investor relative to (i.e. divided by) the total capital paid into the fund by the investor. DPI is thus a multiple of how much a fund has actually returned to investors in relation to what they put into the investment.

Using the example above, if an investor had paid in $300,000 to a fund and received a distribution of $250,000, the DPI at that point would be $250,000/$300,000 or 0.83. DPI will increase whenever additional distributions are made.

Residual Value to Paid-in Capital (RVPI):

Since DPI represents the returns to an investor from actual distributions, it does not include the complete performance picture for an investor until all assets in the fund have been liquidated and distributed. Assets that have not yet been distributed remain in the fund as residual value to investors. RVPI provides a measure of the residual value relative to the paid-in investment at the current time.

The residual value of a PE fund is the fair value of all assets held by the fund. An investor’s share of the fund’s residual value represents an approximation of the undistributed value of their investment. RVPI can be expected to change when a distribution is made or when assets are revalued at the end of a quarter. Residual values are determined by the general partner of the fund in accordance with industry-accepted valuation principles.

If an investor has paid in $300,000 to a fund and the fund now shows their portion of residual value to be $175,000, the RVPI would be $175,000/$300,000 or 0.58.

Total Value to Paid-in Capital (TVPI):

TVPI combines the DPI and RVPI to represent an investor’s total investment value relative to paid-in capital. As the sum of DPI and RVPI, TVPI (also known as the ‘Investment Multiple’) is a measure of fund performance that can be tracked throughout the life of a fund.

Using the example above, if an investor has paid in $300,000 to a fund, received $250,000 in distributions, and has a residual value of $175,000, then their TVPI is ($250,000 + $175.000)/$300,000 or 1.42.

Multiple on Invested Capital (MOIC):

MOIC is another common measure of total fund performance. Similar to TVPI, MOIC combines realised (i.e. distributed) returns with unrealised (i.e. residual) returns and expresses the result as a multiple of the original investment.

MOIC, however, differs from TVPI in two ways:

1. MOIC uses gross returns, whereas TVPI uses returns that are net of fees and carried interest.
2. MOIC displays returns as a multiple of an investor’s total investment commitment,

whereas TVPI presents returns as a multiple of actual paid-in capital, which may or may not equal the investor’s total commitment.

Comparing PE fund performance with public equity

The above performance measures are largely used to compare the performance of private equity funds with other private equity investments. When comparing private equity fund performance to public equity performance in the same time period, a methodology called a Public Market Equivalent (PME) is often used.

Several types of PMEs have been developed. The most common PME methodology is the Long Nickels PME, which is also called the Index Comparison Method (ICM) or simply the PME.

Public Market Equivalent (PME):

The PME compares the performance of a private equity fund directly with the S&P 500 Index. A theoretical investment in the S&P 500 is simulated for the cash flows of the private equity fund. The performance of the hypothetical investment is then measured using an internal rate of return.

Alpha:

The concept of alpha in investments represents the degree to which an investment manager or a fund can outperform a market benchmark or expected return. Alpha is therefore commonly viewed as a measure of a manager’s skill at beating the expected performance of a portfolio with similar risk or a specified benchmark index.

When comparing PE fund performance to that of public equity, alpha would be determined by comparing the performance of a private equity fund to that of a benchmark index such as the S&P 500. When the PME is calculated for a particular PE fund, the performance of the S&P 500 can be subtracted from the performance of the PME to determine whether alpha is positive or negative and by how much. (Positive alpha means the PE fund outperformed the S&P 500 and negative alpha means it underperformed.)

If the annualised PME for a PE fund is 18.2% and the annualised total return performance for the S&P 500 is 14.3 %, then the fund would have a positive alpha of 18.2% – 14.3% or 3.9%.

With regard to PE performance, it should be noted that due to the different skill sets involved in managing public vs. private assets, there has historically been a wider spread between top and bottom performing managers in PE funds vs. top and bottom performing managers in public equity funds.

This means that manager selection in PE is accordingly more important to performance than manager selection in public funds. Moonfare’s relationships with top performing managers and its role in manager selection thus provide an advantage to PE investors in terms of overall performance.

Important notice: This content is for informational purposes only. Moonfare does not provide investment advice. You should not construe any information or other material provided as legal, tax, investment, financial, or other advice. If you are unsure about anything, you should seek financial advice from an authorised advisor. Past performance is not a reliable guide to future returns. Don’t invest unless you’re prepared to lose all the money you invest. Private equity is a high-risk investment and you are unlikely to be protected if something goes wrong. Subject to eligibility. Please see https://www.moonfare.com/disclaimers.