The private equity industry is at an inflection point that its investors can’t ignore. Private assets have attracted significant flows of institutional capital over the last 5-10 years due to their perceived low correlation with public markets and their strong relative performance. Such has been the insatiable thirst for alternatives, that consultancy PwC estimates that investments in private markets will reach between $14-$15 trillion by 2025 – more than 10% of global assets under management and an increase of up to $5.5 trillion from today.
But as markets fluctuate and fears of a global recession have risen since the start of 2022, those same investors who have allocated to private equity funds will no doubt be subjecting their holdings to ever greater scrutiny. To do this, they must ensure they understand how their managers value their assets and they must also seek robust performance measurement metrics.
Number crunching and why investors like DPI
Ascertaining the relative performance of private equity funds can be fraught with difficulty. Amongst the most commonly used metrics is the Total Value to Paid-In Capital (TVPI) ratio, which measures the total value of a fund relative to what its investors have committed. The TVPI metric paints a simple and relatively complete picture of a fund’s performance, as it includes both distributed capital and unrealised capital. However, its reliability becomes more questionable when macroeconomic volatility is high.
This is especially true in funds for which the Distribution to Paid-In Capital (DPI) metric is low. DPI measures the ratio of capital distributed by a fund against the total amount of capital paid into it. This means that at the start of the fund, the DPI will be zero, and will begin to increase as returns are paid out. Once the DPI is equal to 1.0x or 100%, the fund has returned the total capital its investors have committed.
For funds where the DPI is low, the TVPI is therefore largely based upon the unrealised value of the portfolio. This is where subjectivity abounds. Company valuations are determined by the GP, often using a combination of comparable public market valuations and recent comparable transactions. When the economic backdrop deteriorates rapidly, a “comparable” transaction which took place several months ago in a benign market may no longer be a reliable predictor of the value at which the business would transact today.
Inevitably a turbulent macro environment makes valuing private businesses more difficult. However, this problem is substantially less acute for funds with high DPI ratios. If the majority of a fund’s value has already been distributed, this materially de-risks the fund from an investor’s perspective. The divergence between DPI and TVPI in funds raised in the last decade can be seen in the recent BVCA’s Performance Measurement Survey.