Measuring Private Equity: Time Weighted Returns

Money multiples have a fundamental flaw: they do not account for the time value of money: doubling your money in the space of 5 years is certainly better for the investor compared to doubling it in 10 years. To measure how Fund managers have achieved performance across time we can use three metrics: time weighted rates of return, IRR and Horizon IRR.

1. Time weighted rate of return (TWRR) is a concept borrowed from the public market. Essentially, we try to measure the return of an investment without considering the impact of cash flows. In the context of the stock market, simple rates of returns would be calculated between every cash flow. So if the investor buys 10 shares in April, sells 5 in September and then closes his position in December, we would calculate a return between April and September and another one between September and December. A TWRR would then be calculated compounding returns for every period.For private equity, we consider when a fund buys and exits investments. We then calculate the value of the portfolio before and after each transaction. The value of the portfolio is

FV of existing investments + New investments – Exits proceeds

We then compute the periodic return for each year. Calculating the geometric average for the entire period we obtain the TWRR

 

2. Internal Rate of Return: to define IRR we must first start with defining Net present value. The net present value is the sum of the present values for all cash flows discounted at the relevant cost of capital. The IRR is the rate of return that, when used as cost of capital, makes the NPV sum to zero. To compute IRR, we use an iterative process. Or excel, which is usually a lot easier.

 

3. Horizon IRR is simply an IRR computed over a specific time horizon, to see how the performance of the fund has evolved across time. To compute Horizon IRR, we look back to x number of years. For example, for a 1 year horizon IRR, we look back 1 year from now. For a 6 years Horizon IR, we look back 6 years. To do so, we assume Fair value as of that year to be the first cash outflow. We then compute the IRR in the usual manner The Horizon IRR can also be run over any time period, always treating starting fair value as a first cash outflow and last fair value as a final cash inflow.

 

Pros of Time weighted returns

• They take into account the time value of money
• They are a complementary measure of performance together with multiples

 

Cons of Time weighted returns

• They are harder to interpret compared to multiples
• We could encounter situations where IRRs cannot be computed or where an IRR calculation has multiple answers
• IRRs and TWRR are very sensitive to changes in timing of the cash flows. Two funds with the same money multiples could have very different IRRs.
• IRRs assume that all cash distributions are reinvested at a rate equal to the IRR, which is in many cases, not possible.
• Horizon IRR and TWRR use interim Fair values to compute period rate of returns. The Fair values may not be accurate

Measuring Private Equity: Multiples

When general partners report their performance, they typically quote two numbers: return multiples and IRR. Although each taken on its own does not offer a complete picture, when used together these two measures help LPs judge a private equity fund’s performance.

Return multiples are the easiest to calculate and to use. They provide a simple and straightforward way for LPs to quickly grasp what the performance of a fund has been. There are three main return multiples .

1. Distributed to paid in (DPI): also called realised multiple, DPI is computed dividing the sum of proceeds from a fund by the sum of invested capital. DPI is a good measure of performance once the fund starts exiting investments, typically towards the end of its life. If the fund has not exited any investment DPI will be close to 0x, and not provide a very useful insight into the performance.

2. Residual value to paid in (RVPI): also called unrealised multiple, RVPI is calculated by dividing the outstanding fund fair value by the cumulative invested capital. RVPI is a good measure of performance at the beginning of the life of the fund, when no investment has been exited yet. As the fund ages and as investments are exited, RVPI will decrease to 0.

3. Total value to paid in (TVPI): TVPI is the most “complete” of the multiples, and it is computed by dividing the sum of outstanding fair value and proceeds by the total amount invested. It is therefore the sum of DPI and RVPI and as thus can be used to assess performance during the entire life of the fund

As multiples take into account the cumulative invested, disbursed and received amounts, they are a useful indicator of a fund’s position within the J curve. As investments tend to plateau after the end of investment period, which typically lasts 5 years, TVPI tends to stabilize, DPI increases as capital is returned to Limited Partners and RVPI is reduced.

Pros of Return Multiples

• They are easy to calculate
• Thy are easy to interpret
• Finally, multiples are easy to communicate

Cons of return multiples

• Multiples do not take into account the time value of money. Achieving a 3x multiple over 15 years is surely less desirable than achieving a 3x return over 5 years.
• RVPI and TVPI rely heavily on Fund managers’ valuations, which may or may not be accurate.
• Multiples do not take leverage into account. If the fund manager was able to achieve a higher multiple thanks to leverage this is not reflected in the computation.
• And finally multiples do not take into account the recycling of capital. Instead of distributing cash flows, GPs can reinvest the proceeds and thus achieving a higher multiple, as they increase FV and proceeds in the future while the sum of invested capital remains constant