Why the DPI performance metric is so important to investors today

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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.

Competition for investor capital

Using the most appropriate relative performance metric is more important than ever. With pressure on public markets, asset managers’ relative exposure to private equity within their total AuM could rise by virtue of other assets (e.g. equities and bonds) losing value. This is the “denominator effect” that re-emerged briefly during Covid-19, having last become a serious issue post-Global Financial Crisis.

This means that competition for investor capital is more intense than ever. Gaining an accurate insight into how a fund is performing is therefore vital in assisting asset allocators with determining in which funds they should invest their capital. It is likely to make more sense for an Investment Committee or a Chief Investment Officer to sanction reinvesting with a private equity manager that has consistently demonstrated high DPIs and disciplined deployment, rather than one with a history of aggressive valuations that have failed to be met.

This is especially true for managers who have raised funds at significant size uplifts to their predecessors and deployed capital rapidly with limited realisations over the same period. The current market environment may well expose some of these funds. Lofty valuations will now be under pressure given the current macro headwinds, declining public market comparables and a more challenging market for sellers.

Navigating volatility

Today, ECI’s disciplined approach means it has the smallest portfolio in the firm’s history. In the past four years, our total portfolio has halved in size and all 3 of our most recent funds have market leading DPIs. Discipline has been the key to this exit strategy, with our experience over 125 exits enabling us to successfully judge when the right time is to divest.

Inevitably certain more resilient subsectors will be more in demand today than they were 12-24 months ago. Areas such as Digital Healthcare or IoT, two of ECI’s Established Subsectors, continue to offer compelling investment opportunities and long-term growth drivers regardless of broader macro headwinds.

One example of this from ECI’s portfolio within the Digital Healthcare subsector is 4ways, a teleradiology company that provides outsourced teleradiology reporting on diagnostic images. This business is supporting its customers with improved efficiency and accuracy of diagnostics and is helping to tackle the backlog of required scans that built up during the coronavirus pandemic, providing long-term tailwinds and resulting in revenue growth of over 20% year on year.

This demonstrates that there are subsectors that can continue to prosper during tough economic times, but PE firms with an overexposure to the likes of retail and hospitality could find their ability to generate returns challenged over the next two years. DPI will help investors see who has remained disciplined and who can still generate strong realised returns through cycles.

If you’d like to chat with someone at ECI about DPI or any of these questions, please reach out.

About the author

Jeremy Lytle

"I am responsible for ECI’s investors across our current buyout funds, and prospective institutional investors for the future. I enjoy building these long-term relationships and being able to tell the stories about the great businesses we’ve backed."

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