Unlike traditional investment asset classes such as equities and fixed income, private equity is considered an alternative asset class and it has its own set of private equity return measures: Internal Rate of Return (IRR), Total Value to Paid-in (TVPI) and Distributions to Paid-in (DPI).
Keep in mind that all of these measures can be calculated at different investment levels. For example, at the individual deal or portfolio company level, at the portfolio level, or at the overall fund level. Hence, each of these three private equity returns measures can be in terms of gross or net to differentiate between the different perspectives.
Gross returns are those coming directly from the portfolio company or overall portfolio, while net returns are from the perspective of the LPs, which therefore accounts for management fees, carried interest, fund expenses, etc.
The basis for calculating gross and net private equity returns are the corresponding gross and net cash flows between the fund and the underlying portfolio companies in the case of the former, and cash flow between the LPs and the fund for the latter.
Gross & Net IRR - Internal Rate of Return
Books can be written about IRR, its definition and theoretical basis, how it’s calculated, etc. However, this article emphasises the main characteristic of IRR in the context of private equity returns and how IRR accounts for time. This emphasis is vitally important because:
(a) Private equity is inherently an illiquid asset class (i.e. you can’t simply divest and sell your positions instantaneously whenever you want to like you would for listed stocks)
(b) LPs usually invest in closed-end private equity fund structures and entities, i.e. most private equity funds have a fixed term or fund life which is normally in the range of 8 to 10 years, plus the option to extend by single years for 2 to 3 more years depending on the fund’s investment strategy and the rules stipulated in the Limited Partnership Agreement (LPA).
And so, because time is an important issue in private equity, IRR is one of the key measures to use for private equity returns. Put simply, a 2x cash-on-cash return within a year would be a very good outcome, but that same 2x return after waiting 13 years wouldn’t be so attractive. IRR distinguishes between the 1 year and 13 years time horizons.
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TVPI - Total Value to Paid-in
Nomenclature: TVPI can also be referred to as Gross Multiple or Net Multiple (as the case may be) or Multiple of Investment Cost (MOIC), but regardless of how you refer to it, it is expressed as a multiple and the calculation is simply a ratio of Total Value over Paid-in, where Total Value is the sum of Distributions and Unrealized Value, and Paid-in is the invested amount.
As explained above, TVPI can be expressed as a gross or net figure depending on which perspective or level of investment that you are referring to, and depending on if it’s gross or net, there are some nuances to be aware of.
If it is a Gross TVPI (i.e. gross multiple) for an individual portfolio company, then this deal’s TVPI would be calculated as Realised Value plus Unrealized Value, divided by the Invested Amount. If it is a Net TVPI for an LP’s investment into a private equity fund, then TVPI would be calculated from the LP’s point of view as Distributions Received plus Remaining NAV, divided by Capital Calls Paid into the fund.
TVPI is a unique and important private equity return measure because it captures (a) the liquidity coming back from an investment, (b) the remaining upside still in the investment, and (c) the risk exposure in the investment.
DPI - Distributions to Paid-in
Like TVPI, DPI is also expressed as a multiple where it’s the ratio of Distributions over Paid-in. A gross DPI, or realization ratio, at the portfolio company level would be Realised Proceeds coming from this deal back to the fund divided by Invested Amount into this deal.
However, it is more common to express DPI on a net basis from an LP’s perspective, where it is calculated as Distributions received from the fund divided by the LP’s Capital Calls paid into the fund. Net DPI can also be referred to as a cash-on-cash multiple or returns because that is what this private equity return metric is showing: liquidity.
Applying Return Metrics to Subsets of Deals & Investments
Now that we know how to understand, interpret and calculate these private equity returns, it is important to note that this measure can also be applied to a subset of deals or investments, and not just a single portfolio company or fund.
For example, a GP is running a diversified global private equity fund that invests in different market segments (e.g. middle and upper middle-market growth equity and buyouts) across different regions (e.g. US and Europe) and industries (e.g. IT, Healthcare and Industrials). As an LP, you should calculate the gross IRR, TVPI, and DPI for this GP’s buyout deals in Europe that were within a specific investment size, and compare that against its performance for similar deals in the US.
More importantly, you can benchmark this GP’s returns in these segments against comparable deals in the private markets to clearly see if this GP is outperforming. You know what people say, “it’s all relative”, so just looking at private equity returns without seeing how they compare to peers on an apples-to-apples basis is simply meaningless.
But remember, to analyze and benchmark private equity returns on an IRR, TVPI and DPI basis, first and foremost, you need to have the gross and net cash flows and a flexible due diligence platform that will allow you to perform these analyses in an easy, efficient and scalable way. Plus, you also need a comprehensive private markets database that is also built in the same way with gross and net cash flows on actual private markets transactions.
