Evaluating GP, just looking at IRR and DPI is not enough

Choosing a good PME is the embodiment of LP skills.

#1 Assess fund performance, there are usually 4 indicators

There are several commonly used indicators for evaluating the performance of private equity funds. We have analyzed them in detail. In short, there are four types:

(1) IRR: Internal rate of return

IRR is currently a commonly used indicator because it incorporates the time value of funds into the calculation. In the early period of the PE fund, there is only negative cash flow, because the project is not withdrawn, in order to calculate the IRR, the fair value of the investment project is often used as the cash inflow.

However, IRR is not a perfect measuring scale, because it tends to shorten the LP’s vision and hurt long-term investment. The initial IRR of private equity funds is quite misleading. In the calculation process, the short-term small project IRR has a relatively high relative ratio, but the absolute return value is not much; the long-term high investment project has a long investment cycle and large initial investment, so the calculated IRR is often low.

(2) DPI: Dividend multiple of invested capital

Indicators like IRR cannot help LP measure this investment during the investment period, but there are some indicators that can do this, one of which is DPI, the dividend multiple of the invested capital.

The calculation of DPI is the dividend to LP/capital invested by LP, and finally a ratio similar to multiples, such as 1x, 2x, 2.5x, etc. The higher the number, the better. If measured by DPI, the performance of Fund A is obviously better. Although it took more money from LP, it actually brought more returns and avoided the “paper rich” situation.

(3) RVPI: Surplus value of invested capital

Someone joked that RVPI is the younger sibling of DPI who hasn’t grown up yet. why? Let’s take a look at what “surplus value” is.

Residual value refers to the total amount of funds and assets remaining in the investment. After the fund pays off its assets and liabilities, the remaining money is the surplus value, or unrealized income.

In addition, LP’s investment contribution (contribution) is part of the surplus value and cannot be regarded as a liability. If LP wants to see the future investment potential of a GP, or has more money on hand to pay close attention to, it may rely more on RVPI.

(4) TVPI: multiple of total revenue

Another indicator that is not frequently used but worth mentioning is TVPI, which is the total return multiple. Although LP generally does not bother to calculate this indicator, when GP reports this indicator, LP will feel good, and when GP starts to raise the next fund, LP will study this indicator more carefully.

The total return is the sum of all dividends and residual value. The formula for calculating TVPI is (dividend + residual value)/capital invested by LP.

These indicators together form a huge toolbox that can better measure fund performance, but they need to be used together to be more comprehensive, and they need to be opened at the right time.

#2 When the fund matures, the road is hindered and long

The world’s top alternative asset management company and LP Gatekeeper, Cambridge Associates (hereinafter referred to as CA) will publish the Private Investment Benchmark every year, and provide LPs with funds through tracking and researching thousands of funds of different asset classes, different strategies, regions and maturity stages around the world Investment decision support across time, region, and asset class.

They shared a very interesting study, which surprised some of the most experienced family offices and retirement funds. The following is a direct conclusion.

(1) The funds invested for you each year are ranked according to TVPI/IRR performance, and it is impossible to distinguish between the best and the worst funds.

If you use quartile ranking (25% ranking) to measure the performance of the fund every year, the best fund and the worst fund will be in the top 25%, 50%, 75%, and bottom 25% in different years. Repeated horizontal jumps in the classification, this makes CA also a headache.

(2) Fortunately, after 6-8 years, the fund’s performance ranking will stabilize.

Two things need to be noted at this time. First, the time for different asset classes to enter the stable period is different. VC and Fund of Funds are the longest (7-9 years), and S funds are the shortest (5-7 years). Second, even if it enters a stable period, funds that can be used to compare performance appropriately need to distinguish between the stable periods of IRR and TVPI, and it is not feasible to compare them directly.

As shown in Figure 1, whether measured by IRR or TVPI , the maturity periods of different types of private equity funds are very different. The average settlement period for private equity, private equity, real estate private equity, and private natural resources is 6-8 years. Early-stage venture capital strategies and more complex fund structures like fund of funds will take a little longer, 7-9 years before they can be seen. Work is a mature fund. The investment objects of the S fund are more mature, so its settlement time is relatively short, which is 5-7 years.

Evaluating GP, just looking at IRR and DPI is not enough

figure 1

By asset class, the time required for different funds to enter the final quartile ranking

(The horizontal axis is the number of years that TVPI and IRR have entered a stable period, not the investment performance data itself)

In addition, compared with IRR, the settlement time of private equity investment funds measured by TVPI will be longer (Figure 2). When studying different strategies, the result range of TVPI (7-9 years) is more dispersed than that of IRR (5-9 years). This difference is also meaningful, because the calculation of IRR is different from TVPI. As mentioned earlier, IRR includes the time factor, so it is very sensitive to the time distribution of cash flow. The result calculated by IRR will be sustained by the investment strategy. The impact of differences in time and cash flow patterns.

Evaluating GP, just looking at IRR and DPI is not enough

figure 2

From the perspective of IRR and TVPI, the time required for different asset classes to enter the final quartile ranking

In the long maturity period of the fund, LP will always want to base on the existing quartile ranking of a fund (Quartile Ranking, a common way for LP to evaluate the relative performance of GP, namely divided into four quartiles, each quarter 25%) foresee the final ranking of this fund, which is the final performance of this fund. But in fact, the trend of most funds may be ups and downs. The performance of the fund is not stable, and it is difficult to infer the ultimate performance of the fund based on the current ranking.

Looking at Figure 3 again, take the US venture capital as an example. If measured by IRR, 85% (87% if measured by TVPI) of funds will be in three to four different quartiles throughout their life cycle. Jump back and forth.

Evaluating GP, just looking at IRR and DPI is not enough

image 3

Therefore, if you pay too much attention to fund performance early in the fund’s life cycle, it is easy to draw wrong conclusions and affect subsequent investments. The difference between winning and losing may lie in whether a fund’s performance is viewed with the right benchmark at the right time.

What should LP do?

In the general private equity fundraising cycle, GP will first raise a fund, and then invest most of the money in the first 2-4 years. Then, before the end of the entire investment cycle and the reduction of management fees, the core decision of the next fund of GP was also made. This situation further illustrates our previous view that LPs should not draw conclusions based on the short-term performance of the portfolio, but take time to understand a GP’s investment style, investment strategy, consistency and execution ability.

But as we discussed above, the process and time of fund settlement is very long, and the experience during the period has been twists and turns. What benchmark should LP use to look at their GP and make further decisions about whether to invest?

#3 PME: One of the tools to set the benchmark

LP must first establish a handy benchmark. In addition to the fund performance toolkit mentioned at the beginning, PME (Public Market Equivalent) is also a choice.

There are several advantages to using PME to evaluate performance. First of all, PME allows LPs to clearly see what kind of return on investment they will get if they put the part of the money invested in private equity GPs in the secondary market. In other words, PME exchanges the money invested by LPs in private equity into the open market, which can objectively reflect the performance of GPs than IRR. In addition, PME is a relatively straightforward calculation and more transparent than IRR.

There are three other calculation methods for PME, namely Long-Nickels PME (LN-PME), PME+ and Kaplan-Schoar PME (KS-PME).


The calculation principle of LN-PME is that it uses the cash flow of private equity funds to create an investment hypothesis for the S&P index, which is to compare the performance of private equity funds with the S&P 500 index.

Most people will use the S&P 500 index as a template for comparison, but LN-PME can also calculate any other index. But the disadvantage of LN-PME is that it is based on a hypothetical basis. Another problem is the application of LN-PME in IRR calculations.

This leads to further iterations of LN-PME: PME+ and KS-PME.

(2) PME +

PME+ uses the same method as LN-PME, but it can avoid negative NPV. Simply put, it can adjust cash flow to ensure that there is no big difference, but this is also the bad side of PME+: PME+ will affect cash flow. Therefore, the cash flow of the fund does not completely match in the end, and the LP cannot directly compare the results. Similar to the LN-PME method, the calculation of PME+ is still the same as IRR.

(3) KS-PME

Among the performance standards provided by Pitchbook, KS-PME is clearly used as the gold standard for benchmarking analysis. It can directly compare the performance of target private equity funds with the performance of sample funds. Unlike the previous two methods, KS-PME provides a market-adjusted cash multiple. The calculation result is intuitive: if the KS-PME is higher than 1, the private market fund will perform better than the public market index; if the final value is lower than 1, the performance will be poor. KS-PME is also as flexible as other PME calculations.

Of course, there is no all-round tool in the investment world, and PME is not an unblemished benchmark. Based on the relevant data compiled by Guangzheng Hang Seng, we have summarized the following limitations.

First, when the private equity portfolio greatly exceeds the benchmark, the net asset value of the secondary market may become negative. At this time, it is meaningless to use PME to compare long-term private equity investment income with short-term secondary markets.

Secondly, due to the similar calculation principle, PME also faces the same problem as IRR, that is , it does not consider that the general size of portfolio is smaller than that of listed companies (most of these companies should be small-cap stocks), and it is difficult to calculate and deal with irregular cash flows. .

In addition, PME relies on the timing of private equity funds, so just looking at PME indicators will cause investors to disrupt the rhythm of buying or selling shares.

Finally, PME cannot adjust the risk difference between the private equity portfolio’s cash flow and the secondary market index, or the tax impact of investment income returns.

#4 Use patience to harvest long-line fruits

To make a good investment plan, you must first set up an appropriate benchmark, but even a seasoned LP can’t do it easily when measuring fund performance. The lag of investment performance reports, the constraining of funds during the lock-up period, and the struggle in the downward period of the J curve have made measuring performance and setting benchmarks more confusing.

Therefore, LP will gradually find that it is still a long and winding process to fully understand the performance of private equity funds. When evaluating performance, you also need to take a long-term view. Because it usually takes 6-8 years for a fund to mature and stabilize to the final real level. Therefore, the ranking of most funds is actually not accurate, and only represents the state at a certain point in their life cycle. When setting the benchmark, an LP with a longer-term perspective can select a suitable GP on a more stable and realistic plane.

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Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/evaluating-gp-just-looking-at-irr-and-dpi-is-not-enough/
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