As you may have seen in our Private Capital: Risk, Returns, and Benchmarking lesson, calculating performance within private markets can be complex, primarily due to the irregular timing of cash flows between investors and fund managers. Let's explore benchmarking returns and the different types of performance metrics.
Calculating returns
Below we examine two ways to calculate performance. The time-weighted rate of return (TWRR) is typically used to measure the performance of open-end, evergreen, and public market funds, while the internal rate of return (IRR) is typically used to assess the performance of closed-end private market funds.
The time-weighted rate of return measures fund performance over a specific time horizon by compounding returns calculated in each sub-period.
The formula leaves out the total amount of investor contributions and withdrawals during the time horizon under consideration, which is why this method is commonly used to measure the performance of public market funds. That’s because in public markets, investment managers have no control over when investors choose to move their money in or out of their funds.
Gross IRR (internal rate of return)
Gross IRR measures the return from an investment at the fund level, but before deducting any fees or costs. As the mathematical formula shows, it is the discount rate that makes the net present value of all cashflows generated by the investment equal to zero.
Net IRR, unlike gross IRR, accounts for all fees and costs, such as the management fees and carried interest of the general partner (GP).
Calculation definitions:
End value of investment
Cashflow
Beginning value of investment
Examples of performance metrics include the internal rate of return (IRR), distributions to paid-in capital (DPI), residual value to paid-in capital (RVPI), total value to paid-in capital (TVPI), and capital called. A benchmark will ‘average’ these metrics across a peer group of similar funds. These metrics can be calculated on a median, average, pooled, or weighted basis for a particular reporting date. Investors may then use the benchmark to determine relative performance.
TVPI (total value to paid-in capital)
The TVPI multiple captures both the total amount distributed to investors in a fund as well as the residual value of unrealized assets in the fund (i.e. the value of portfolio companies which have yet to be exited). It is the sum of DPI plus RVPI, divided by capital called.
RVPI (residual value to paid-in capital)
RVPI shows the value of any remaining assets held by a private capital fund (the residual value) as a multiple of the sum limited partners (LPs) have invested so far (the paid-in capital). Dividing the current fair value of the fund’s investments by capital called generates the RVPI ratio. As with DPI, RVPI typically excludes fees and costs.
DPI (distributions to paid-in capital)
DPI shows how much investors in a private capital fund have received (the distributions) as a multiple of the sum they have invested so far (the paid-in capital). Dividing the amount distributed to LPs by the amount LPs have transferred to the fund – also known as “capital called” – generates the DPI ratio. DPI typically excludes fees LPs have paid to the GP, such as management fees and carried interest.
Capital called
Capital called is a measure of the amount LPs in a fund have transferred to the GP to finance the acquisition of assets up to a point in time. To calculate the capital called ratio, divide the total sum invested by LPs (the total LP contribution) by the amount LPs have pledged to invest over the fund’s life (the total LP commitment). This calculation typically includes management fees and expenses. The formula below shows how to calculate capital called as a percentage.
Public market equivalents
Financial performance in private markets is assessed in several ways. For example, an investor can benchmark based on average performance, or by analyzing the risk-and-return profiles in a peer group of similar funds. This peer group can then be compared to a public market equivalent (PME) or a relative private market index.
What is a public market equivalent?
Public market equivalents (PMEs) add another layer of context when benchmarking financial performance by offering an insight into the equivalent performance of a public market investment.
This helps to demonstrate whether an investment in a private market fund outperformed what the investment could have returned if allocated to a similar public market asset instead. As investing in private markets often means lower liquidity and longer investment horizons, understanding return in comparison to liquid, shorter-term public markets helps to inform key performance analysis.
Summary
With the variety of asset classes and strategies in alternatives, it's important to understand the unique attributes of each investment and to measure performance in a way that best reflects each strategy.
When looking to compare performance within private markets, using the money-weighted return calculation helps to paint the most accurate picture of a portfolio’s performance due to its granularity in accounting for varied cashflows throughout the investment lifecycle. Preqin’s private capital benchmarks use money-weighted returns to compare fund managers within peer groups. Transaction Intelligence and the Horizon IRR indices also use money-weighted returns to reflect deal-level and market-segment performance respectively.
When looking to view private market performance within the context of a broader public and private market portfolio, using time-weighted returns (TWR) enables like-for-like comparison. The Preqin Quarterly Index uses TWR to showcase performance across public and private market asset classes.
