Professional Documents
Culture Documents
The costs associated with private equity investments are much more significant than the cost of
investing in public companies. Costs of investing in private equity can be broken down into:
t Transaction fees. These include costs of due diligence, bank financing costs, and legal
fees for acquisition and sale transactions in portfolio companies.
t Investment vehicle fund setup costs. These include legal costs of setting up the investment
vehicle (e.g., limited partnership, company limited by shares) and are amortized over the
vehicles life.
t Administrative costs include custodian, transfer agent, and accounting costs and are
usually charged as a percentage of the funds net asset value.
t Audit costs are fixed annual charges.
t Management and performance fees for PE funds are typically higher than that for plain
investment funds. In the private equity industry management and performance fees are
around 2% and 20% respectively.
t Dilution. Shareholders suffer dilution of their equity interests in portfolio companies from
additional rounds of financing and from stock options granted to management.
t Placement fees. These are charged by placement agents who raise funds for PE firms.
Placement fees may be charged upfront (usually 2%), or as trailer fees that are charged
annually as a fraction of the amount invested by limited partners, as long as the amount
remains invested.
LOS 40h: Interpret and compare financial performance of private equity funds
from the perspective of an investor. Vol 5, pp 161164
Evaluating Fund Performance
The performance of a private equity fund may be evaluated using either the internal rate of return
(IRR) or a multiplesbased approach.
Internal Rate of Return (IRR)
IRR is a cashweighted (or moneyweighted) return measure that accounts for the time value of
money. IRR is the recommended measure of private equity performance according to the Global
Investment Performance Standards (GIPS) and other venture capital and private equity standards.
However, in a private equity setting, the IRR should be interpreted with care because it assumes
that interim cash flows are reinvested at the IRR, whereas NAV is primarily illiquid for most of a
PE funds life. IRR may be calculated gross or net of fees (management fees, carried interest, etc).
t Gross IRR relates cash flows between the private equity fund and its portfolio companies.
It is therefore, a relevant measure for evaluating the PE firms ability to create value.
t Net IRR relates cash flows between the private equity fund and LPs and is therefore, a
relevant measure of return to investors.
68
2015 Wiley
Multiples
Multiples simply measure the total return to investors relative to the total amount invested.
Although they ignore the time value of money, multiples are popular among the LPs because
of their simplicity and ability to distinguish between realized returns (proceeds from actual
successful exits) and unrealized returns (based on the GPs estimates of NAV).
Quantitative Measures of Return
The most commonly used multiples are:
t Investments realized since inception. All successes and failures should be evaluated.
t Unrealized investments. Troubled portfolio companies should be identified and the
expected time to exit should be estimated for each portfolio company.
t Cash flow forecasts for each portfolio company and for the overall portfolio.
t Portfolio valuation, NAV, and audited financial statements.
For example, consider a fund that follows a venture capital strategy in tech companies. This fund
had a vintage year of 1999 and a term of 10 years. Five years into its life (midlife) the fund had a
DPI of 5% and a RVPI of 52%.
The TVPI of 57% indicates that the Jcurve for this fund will probably be extended. The fund
is halfway into its life and LPs total return (realized and unrealized) is still well short of
committed capital. Further, the bulk of the return is unrealized (as RVPI is significantly greater
than DPI) which suggests that the fund has been unable to harvest many of its investments. Given
that the fund was formed just before the Internet bubble burst in 2000, we can infer that exit
opportunities must have diminished and the fund may have had to write off some investments.
2015 Wiley
69
In this situation, the LPs should carefully evaluate existing companies in the funds portfolio and
carefully scrutinize the GPs valuations of those companies to ensure that they are not inflated
given the bleak outlook for the technology sector. See Example 5-1.
Example 5-1: Comparing Private Equity Fund Performance
An analyst gathered the following information regarding two private equity funds:
Fund
Fund A
Fund B
Gross
IRR
18.4%
2.1%
Net
IRR
12.1%
0.2%
DPI
1.21
0.26
RVPI
1.35
1.08
TVPI
2.56
1.34
Performance
quartile
1
2
Maturity
of fund
7 years
3 years
70
2015 Wiley
LOS 40i: Calculate management fees, carried interest, net asset value, distributed to
paid in (DPI), residual value to paid in (RVPI), and total value to paid in (TVPI) of a
private equity fund. Vol 5, pp 161164
Example 5-2: Calculating Performance Measures
Gamma Fund has committed capital of $250 million. The general partner (GP) of the fund is paid carried
interest of 20% if the funds NAV before distributions exceeds committed capital. Further, the fund
charges a management fee of 3% of paidin capital. The following table provides information regarding
the funds capital calls and performance for the first 7 years of its life.
Year
1
2
3
4
5
6
7
1.
2.
Operating Results
30
20
5
70
80
100
155
Distributions
40
80
120
Calculate paidin capital, management fees, NAV before distributions, carried interest, and NAV
after distributions for each of the 7 years.
Calculate the funds DPI, RVPI, and TVPI at the end of 7 years.
Solution:
Capital
Called Paidin
Years Down Capital
1
2
3
4
5
6
7
1.
70
50
30
20
20
10
10
Management Operating
Results
Fees
70
120
150
170
190
200
210
2.1
3.6
4.5
5.1
5.7
6.0
6.3
NAV before
Distributions
Carried
Interest
37.9
64.3
94.8
179.7
274.0
333.2
400.1
0.0
0.0
0.0
0.0
4.8
11.8
13.4
30
20
5
70
80
100
155
Distributions
NAV after
Distributions
40
80
120
37.9
64.3
94.8
179.7
229.2
241.4
266.7
Paidin capital (PIC) simply equals the cumulative amount calleddown. For example:
PIC (Year 6)
70
50
30
20
20
10
$200m
Management fees for each year are calculated as 3% of PIC. For example:
Management fee (Year 6)
2015 Wiley
200
3%
$6m
71
229.2
10 6
100
$333.2m
The GP starts earning carried interest once the funds NAV exceeds committed capital
($250m). This occurs in Year 5, when the funds NAV before distributions equals
$274m. Therefore, carried interest will be paid as 20% of the excess.
Carried interest (Year 5)
( 274 250)
20%
$4.8m
Carried interest in each subsequent year will be paid on the increase in NAV before
distributions over the year.
Carried interest (Year 6)
NAV after distributions
( 333.2 274 )
$11.8m
20%
333.2 11.8 80
$241.4m
A DPI greater than 1.0 indicates that LPs realized return already exceeds the amount
they invested in the fund.
RVPI equals the value of LPs shareholdings held with the fund as a proportion of
cumulative invested capital.
RVPI
RVPI
DPI
RVPI
2.4129
The TVPI indicates that when realized and unrealized returns are combined, LPs
should expect to earn almost 2.5 times their investment in the fund once all the funds
investments have been harvested.
72
2015 Wiley