To help institutional investors better understand whether their private equity portfolios are performing well, Callan recently published “The Keys to Unlocking Private Equity Portfolio Assessment,” covering performance measurement and benchmarking for this asset class. In this blog post we focus on how performance for private equity is calculated and how it differs from return calculations for publicly traded securities.

Returns

All publicly traded asset classes (i.e., stocks and bonds) and private open-end vehicles (e.g., hedge funds and core real estate) use a time-weighted return calculation (TWR). However, the CFA Institute’s mandated Global Investment Presentation Standards (GIPS) calculation for closed-end private equity vehicles is internal rate of return (IRR):

TWR: An equal-weighted return linking a series of individually calculated returns (e.g., quarterly) to provide a return over any cumulative period. When a new period’s return is produced, it is appended to the existing series. With an equal-weighted return, an investor can have $100 invested in the portfolio one quarter and $1,000 the next, and the TWR will be as if the same amount were invested in each quarter.

The equal-weighted calculation is considered most appropriate for assessing public market managers because the investor controls the dollar-weighting over time by having the freedom to make contributions and redemptions. Therefore, the manager can only be held responsible for the profitability of the return but not the amount of capital to which the return is applied.

IRR: A capital-weighted return that provides a single cumulative figure since inception. IRR is not a series of linked returns. When a new period’s data (additional cash flows and a new ending value) are available, the entire return is recalculated from the inception date.

This dollar-weighted calculation is considered most appropriate for assessing private closed-end fund managers (and their portfolios). After making the initial commitment, the investor does not control when the capital is called or distributed, so the manager is held responsible for both the amount of capital at work and its profitability.

All percentage return calculations can help estimate economic value creation, but each has drawbacks. TWRs provide an indication of either a manager’s or the portfolio’s profitability, but not the actual investor’s profitability, since capital weighting is not applied. IRRs are very sensitive to cash flows early in their calculation period, so large early cash outflows can permanently skew returns in an outsized positive manner. Thus, one can have a high IRR even with an investment providing relatively low profitability. Conversely, as the IRR calculation timeframe extends, the calculation becomes static, varying little even with meaningful cash flow or valuation changes. Unfortunately, one cannot detect these effects by simply looking at the IRR on a standalone basis.

Performance Ratios

The private equity industry also uses a set of three performance ratios to assess returns, comparing interim performance to the amount of capital paid-in to a private equity partnership or portfolio. All of the ratios are dynamic and will change with time.

DPI: Distributions divided by Paid-In capital. This ratio measures relative liquidity by how much has been cumulatively distributed so far. Notionally, a DPI ratio of 0.60x means that 60 cents has been distributed to investors for every dollar contributed.

RVPI: Residual Value (aka Net Asset Value or NAV) divided by Paid-In capital. This ratio measures how much unrealized value remains in the investment. A RVPI ratio of 0.70x means that the remaining investments are valued at 70 cents for every dollar contributed.

TVPI: Total Value (Distributions + Net Asset Value) divided by Paid-In capital. This measures the total gain. A TVPI ratio of 1.30x means the investment has created a total gain of 30 cents for every dollar contributed. TVPI is composed of both returned capital and residual value (e.g., DPI of 0.60x + RVPI of 0.70x = TVPI of 1.30x).

Most private equity managers assert that they are trying to achieve a 2.0x return and an IRR in the mid-teens or higher; however, returns at these levels are less consistent than one might hope. A successful, broadly diversified portfolio that is mature (has a significant number of partnerships both ramping up and liquidating) will generally settle in at a TVPI in the range of 1.60x, which will equate to an IRR in the low-teens.

Callan prefers using TVPI for evaluating partnership performance, given that the key purpose of private equity investing is to secure large dollar gains over time. With TVPIs, the underlying economics of the investment are more evident than with percentage returns. If the TVPI is 1.30x, the 30 cent profitability is understandable (you know how much food it can buy). Percentage calculations are less concrete, which is reflected in a well-worn private equity industry aphorism: “You can’t eat IRR.”