Performance measurement for private equities

Wednesday, June 24, 2020 | By Ian Searle, Head of Performance & Attribution for EMEA, SS&C Technologies

Performance measurement for private equities

Recent volatility in markets worldwide is a timely reminder of the benefits of diversification in an investment portfolio.  Since 2000, investment in private equity (PE) has significantly increased and provided investors greater diversification across growth assets. Over this time, private equity’s net asset value rose more than sevenfold globally, and PE-backed companies more than doubled to over 8,000 just in the USA, while the total number of publicly owned companies saw a modest decline. The increased usage of PE as an asset class across pension schemes, sovereign funds and wealth investors has created a need to provide analysis that accurately captures the investment performance of both the general and limited partners, across which fund expenses and distributions are allocated.

For most investment portfolios and asset classes, the traditional approach to measuring performance has been to use the time-weighted rate of return. This has developed over time from the original Dietz formula, which captured capital flows in and out of a portfolio, on to Modified Dietz, where the timing of cash flows are taken into consideration, and more commonly now the use of daily return calculations.  The underlying premise to these calculations is to minimize or negate any impact of cash flow when measuring performance, since the investment manager has no control over the timing of a cash flow.

Why is private equity different? With PE, the opposite is the norm; the manager not only has control over the selection of investments, but also the timing of any drawdown of committed capital. As a result, managing cash flows is a key component of PE performance, and the preferred metric is the Internal Rate of Return (IRR), which measures profitability. IRR is sometimes referred to as "discounted cash flow rate of return" and is usually measured over the life of the investment (since inception) as an annualized figure.

Alongside the use of IRRs as the primary measure of PE performance are a number of key additional metrics. Total Value to Paid In capital (TVPI) gives the ratio of current value to the sum of the funds drawn down into the fund, less distributions, but unadjusted for capital cash flows. This limitation means that it is usual to see TVPI quoted alongside IRR. Distribution to Paid In capital (DPI) gives the ratio of distributions to the total paid in capital, also measuring the scale of returns an investment has given. As with any investments, analysis across a range of statistics gives a broader understanding of the returns being generated.

Investors need a sophisticated performance measurement system to support the complexities of PE investment tracking across current value, committed capital, capital drawn down, distributions (both cash and stock), and the input of these measures to commonly reported ratios.  With the right tool, performance can be measured for a distinct PE general partnership, or at the asset or asset-class level, when part of a diversified portfolio of investments.

With a system like SS&C Sylvan, investors may load any number of user-defined portfolio and security properties and then leverage the solution’s ability to capture the key values and metrics that bring greater clarity into the performance of their PE investments.

Asset Management, Wealth Management

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