Han Dieperink: The return on private equity

April 30, 2024

^{This column was originally written in Dutch. This is an English translation.}

By Han Dieperink, written in a personal capacity

In private equity, returns are usually calculated using the internal rate of return. While this method is not without shortcomings, it is the least bad measure for this asset class.

For most investment categories, the time-weighted return is the best way to calculate returns. Because this method looks at the return over fixed periods of time and does not take into account interim deposits or withdrawals, it provides a clear picture of the performance of an investment fund or asset manager. This also makes for a clean comparison with an index or benchmark.

A disadvantage for the client is that such a return can give a distorted picture of reality, especially if a large deposit or withdrawal has taken place. For example, the return can be positive, while the portfolio value has fallen below the investment. This does not detract from the manager's performance, but says more about the period in which the greatest return was achieved.

Internal rate of return

Returns in private equity are usually calculated using the internal rate of return, or IRR, a measure that expresses cumulative returns over time. IRR is therefore sensitive to sales that occur early in the life of the fund, which makes long-term investments less interesting for private equity. Many private equity funds are therefore taking measures to increase the IRR.

For example, existing credit lines are used to postpone the moment of requesting the investor's money for as long as possible. This means that the committed capital (on which costs are calculated) is already put to work, but it does not count for the calculation of the IRR. After all, IRR is calculated on the invested capital. Another way to increase the IRR is by borrowing money with the value of the fund as collateral, in order to repay participants as quickly as possible.

Multiple measures

To neutralize the shortcomings of IRR, other methods are often looked at to calculate returns. For example, the multiple on invested capital (MOIC), the distributed to paid-in capital (DPI), the total value to paid in capital (TVPI), or the many variants thereof (with just as many abbreviations) are usually also considered. However, they do not take the time factor into account.

This makes it impossible to compare one investment with another or to compare it with an index. After all, it makes quite a difference how long it takes before, for example, a doubling of the capital occurs. A doubling in one year is much more impressive than, for example, a doubling in seven years. Furthermore, these multiples usually look at the invested capital, often minus the costs that have to be paid on the committed capital, all things that ensure a higher multiple.

Public market equivalent

To compare the returns with a portfolio of listed shares, there is also the public market equivalent (PME). This shows the relationship between the value development of a fund and the value development of a stock market index. To this end, the amount and timing of the cash flows (capital calls and distributions) in a private equity fund are simulated with equal investments in a shadow portfolio that invests in the index. A PME of 1 then means that the fund has achieved a return comparable to the index.

This method is used to demonstrate that private equity has not added much value compared to listed investments since the Great Financial Crisis. This is because in these studies private equity is always compared with the S&P 500. However, over the past fifteen years the return on the S&P 500 has been approximately double that of the world index.

The reason for this is that the companies in the S&P 500 have started to behave like private equity. With the hot breath of private equity funds on their necks, capital ratios were optimized, partly made possible by the extremely low interest rates. Foreign capital was attracted to purchase shares. Over the past fifteen years, the companies themselves have been the most important purchasers of their own shares. Furthermore, the management of Anglo-Saxon companies in particular was increasingly held accountable for the development of earnings per share, the ideal way to parallel the interests of shareholders and the company.

Partly because the companies in the S&P 500 started to resemble private equity, the S&P 500 has achieved an exceptional performance. That does not detract from the performance of private equity. Moreover, the dispersion of returns within private equity is much greater than with stock market investments. So it makes quite a difference which fund is selected. The best funds perform much better than the index average.

IRR is the least bad measure

There may be shortcomings in IRR, but compared to many other measures it is the least bad measure for assessing returns. Moreover, it illustrates the essence of investing in private equity: in order to convert IRR into real returns, as much money as possible must be put to work.

Anyone who invests in a 'traditional' private equity fund knows in advance that there is a big difference between committed capital and invested capital. Typically, the investor is only half invested over the life of the fund. After all, the first cash call is often only a fraction of the committed capital. Although the intention is that everything has been invested after five years, in practice this is often no more than 80%. This may also be because investments have already been partially repaid before then.

Investing well in private equity is largely about managing these cash flows well. With the help of secondaries and co-investments, for example, it is becoming increasingly easier to manage these cash flows and thus remain fully invested. In this way, IRR is ultimately converted into real returns. The advice as an individual investor is therefore not to invest in individual private equity funds (or the investor must be able to invest in dozens of funds), but to leave the management of these cash flows to a professional manager.

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