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Private equity investment returns can be a complex and nuanced topic, but with the right guidance, you can make informed decisions about your investments.
Historically, private equity investments have outperformed public markets, with a 10-year median return of 12.4% compared to 9.8% for the S&P 500.
A key factor in private equity's success is the ability to hold investments for longer periods, allowing for more strategic decision-making and a focus on long-term growth.
Research has shown that private equity funds with a higher holding period tend to generate higher returns, with a 5-year holding period resulting in a median return of 14.3%.
Investors can benefit from private equity's potential for high returns by diversifying their portfolios and taking a long-term view.
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Performance Measurement
Private equity performance measurement is crucial to evaluate the success of a fund.
The internal rate of return (IRR) is a widely used metric, calculated as the discount rate that makes the net present value of all cash flows equal to zero. It accounts for both the magnitude and timing of returns, making it a time-sensitive measure.
IRR is not the only metric used to evaluate private equity performance. The multiple, also known as Multiple on Invested Capital (MOIC) or Total Value to Paid In (TVPI), represents the value of the investment compared to the cost. It's calculated by dividing the sum of realized and unrealized value by invested capital.
The Distributed Capital to Paid-in Capital ratio (DPI) shows how much money has been returned to the investor compared to the amount invested. It's calculated by dividing distributed capital by called capital.
These three metrics - IRR, multiple, and DPI - provide a more complete picture of a private equity fund's performance. They help investors understand the fund's returns, risk, and potential for future growth.
Here are the key differences between these metrics:
- IRR is time-sensitive, while the multiple and DPI are not.
- IRR and multiple account for unrealized value, while DPI does not.
- DPI is particularly valuable in volatile environments, as it highlights the liquidity of realized returns.
By evaluating these metrics together, investors can gain a deeper understanding of a private equity fund's performance and make more informed investment decisions.
Understanding Returns
Private equity investment returns can be complex and nuanced, but understanding the basics is essential for making informed decisions.
IRR, or Internal Rate of Return, is a key measure of private equity returns, especially for illiquid asset classes like private equity. This is because private equity investments often have a fixed term or fund life, typically ranging from 8 to 10 years, with the option to extend.
Time is an important issue in private equity, and IRR distinguishes between different time horizons. A 2x cash-on-cash return within a year would be a very good outcome, but that same 2x return after waiting 13 years wouldn't be so attractive.
To generate high returns, private equity strategies implement common tactics, but it's essential to understand how these returns are calculated and interpreted.
IRR is one of the key measures to use for private equity returns, and it can be applied to subsets of deals or investments, not just a single portfolio company or fund. This allows LPs to compare a GP's performance in specific market segments or regions.
For example, a GP's buyout deals in Europe can be compared against its performance in similar deals in the US. Benchmarking returns on an IRR basis is essential to see if a GP is outperforming its peers.
However, it's essential to note that IRR is not a rate of return, but rather a measure of return. This distinction is crucial when evaluating private equity performance figures, which are often presented as IRRs.
DPI, or Distributions to Paid-in, is another essential metric for understanding private equity returns. It's expressed as a multiple, where it's the ratio of Distributions over Paid-in.
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Achieving Excess Returns
Achieving excess returns in private equity requires a strategic approach. Private equity strategies implement common tactics to generate high returns.
Investing in smaller companies can be a key factor in achieving excess returns. Investment targets tend to have smaller market capitalizations, implying higher risk and therefore an increased return premium. This is particularly true for private equity managers looking to grow or scale a smaller business by upgrading its management team, acquiring synergistic or complementary businesses, improving operational efficiency, investing in technology, or providing better access to capital.
Time is an essential factor in private equity, with most funds having a fixed term or fund life of 8 to 10 years, plus the option to extend by single years for 2 to 3 more years. This makes Internal Rate of Return (IRR) a crucial measure for private equity returns, distinguishing between different time horizons.
Additional reading: Time in the Market vs Timing the Market Graph
J-Curve Impact on Net IRR
Private equity funds often post negative net returns in the early years of a fund's life, typically because investments are held at cost for some time after the initial purchase.
This is a standard valuation practice in private equity, but it can make the fund's performance appear flat until a meaningful event occurs, such as a sale or another round of fundraising.
Fees, like management fees and organizational fees, are collected early in a fund's life, which can make the negative return appear especially severe for the first couple of years.
As more investments are made and more capital is called, the impact of fees decreases, and successful funds can cross from negative since-inception performance to positive.
This is referred to as a "J-curve" return, where the fund returns are negative in the early years but become profitable in the harvest years.
Early-stage venture capital typically has the most acute J-curve, with high fees and a long time until liquidity, while late-stage venture strategies have the shortest J-curves due to their proximity to the public market.
Buyout funds' J-curves typically fall between those of the other two strategies, and understanding the J-curve is critical because it may impact investor psychology.
Investors often add PE exposure to their portfolios in pursuit of higher returns, but having a portion of their portfolio show negative returns for a few years can be difficult to rationalize.
Private equity funds are long-term investments, and their performance early in the investment phase is typically not indicative of their ability to return capital at a favorable IRR, multiple, and DPI over the full term of the fund.
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How to Achieve Excess Returns
To generate high returns, private equity strategies implement a few common tactics. One of these tactics is to focus on smaller companies, which implies higher risk and therefore an increased return premium.
Private equity managers often look to grow or scale a smaller business by upgrading its management team, acquiring synergistic or complementary businesses, improving operational efficiency, investing in technology, or providing better access to capital.
A 2x cash-on-cash return within a year would be a very good outcome, but that same 2x return after waiting 13 years wouldn’t be so attractive. IRR distinguishes between the 1 year and 13 years time horizons.
Investment targets tend to have smaller market capitalizations which implies higher risk and therefore an increased return premium. This means that private equity managers have more levers to pull at these smaller companies to facilitate strong performance.
Private equity funds that consistently outperform the market do exist, and investing in a well-managed partnership can lead to future success. In fact, one study found that there is a great deal of persistence in private equity performance, suggesting that well-managed partnerships can deliver strong returns over time.
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Leverage
Leverage is a key tactic used by private equity strategies to generate high returns. By utilizing a heavy degree of debt or leverage, private equity funds can finance a portion of the company purchase price.
The cost of debt is typically lower than the return on equity, allowing the returns of the investment to be greatly amplified. This is similar to buying a house, where a homeowner contributes equity capital and uses debt to finance the rest of the purchase price.
However, if debt is unusually expensive or if the company is going through a financial hardship, the company might struggle to cover its debt service cost while simultaneously investing for continued growth. This can negatively impact expected returns for equity holders.
Lower levels of leverage can mitigate this risk but may also lead to lower net returns.
For more insights, see: Debt Security vs Equity Security
Three Thoughts on IRR Tyranny
As we explore the concept of achieving excess returns, it's essential to understand the role of IRR (Internal Rate of Return) in private equity. IRR is a key measure of private equity returns, especially considering the illiquidity of the asset class. Private equity is inherently an illiquid asset class, meaning you can't simply divest and sell your positions instantaneously like you would with listed stocks.
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IRR distinguishes between different time horizons, making it a vital metric in private equity. For instance, a 2x cash-on-cash return within a year would be attractive, but the same 2x return after waiting 13 years wouldn't be as impressive.
Private equity funds often post negative net returns in the early years of a fund's life, a phenomenon known as the J-curve. This is due to investments being held at cost for some time after the initial purchase, while fees are collected early on. However, as the fund matures and investments are written up or realized, successful funds can cross from negative since-inception performance to positive.
To analyze and benchmark private equity returns on an IRR, TVPI, and DPI basis, you need to have the gross and net cash flows and a flexible due diligence platform. Additionally, a comprehensive private markets database with gross and net cash flows on actual private markets transactions is also necessary.
Here's a summary of the key characteristics of private equity returns and their implications:
- IRR distinguishes between different time horizons, making it a vital metric in private equity.
- Private equity funds often post negative net returns in the early years of a fund's life (J-curve).
- A comprehensive private markets database and due diligence platform are necessary for analyzing and benchmarking private equity returns.
By understanding these key characteristics, you can make more informed decisions when investing in private equity.
Market Factors
The private capital markets have experienced significant changes in interest rates over the past few decades. The twenty-first century has seen a range of different interest rate regimes, from the aperiodic near-zero interest rate environment of most of the 2010s to the fluctuations seen in the early 2000s, and now again in the 2020s.
These shifts in interest rates have had a profound impact on private capital markets. The sharp decline in interest rates in the 2020s has led to a decrease in the cost of borrowing for private equity firms, allowing them to take on more debt and invest in more deals.
The varying interest rate regimes have also influenced the types of investments that private equity firms make. For example, in periods of low interest rates, firms may be more likely to pursue leveraged buyouts, while in times of high interest rates, they may focus on more conservative investments.
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Market Inefficiency
In public markets, investors tend to make decisions based on the same set of publicly available information.
Investors in public equities often rely on quarterly earnings, financial statements, and third-party analyst reports to inform their decisions.
Transactions and price discovery occur frequently in public markets, involving a large number of market participants.
This frequent activity makes it more difficult to generate stand-out performance in public markets.
In contrast, private markets have a level of inefficiency that rewards those who have an information edge.
Transactions and price discovery occur infrequently in private markets, contributing to their inefficiency.
Investors in private markets gather information from primary sources, such as industry experts and thorough on-site diligence visits.
This approach allows them to uncover unique insights that others may not have access to.
Limited exceptions exist where investors in public equities do have an information advantage, but these are rare.
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Insulation from Market Volatility
Private equity valuations aren't affected by short-term market fluctuations, allowing asset owners to focus on long-term value creation.
This insulation from market volatility is a significant advantage, as it enables private equity funds to take calculated risks and execute their strategies without being swayed by short-term market trends.
During periods of market distress, public equity investors may need to withdraw their capital, but private equity limited partners can continue to invest in quality assets at attractive discounts.
Private equity funds can take advantage of lower pricing to buy quality assets, which can be a valuable opportunity for growth and returns.
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Is It a Good Time to Invest?
If history is any guide, many of the new private equity partnerships formed in the last several years will disappear. According to Kaplan, the results suggest that private equity returns from recent funds will continue to be poor.
Private equity returns from recent funds will continue to be poor, but the "good" general partners, and particularly those whose funds did not grow too much, will still outperform the benchmarks. This is based on historical patterns.
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From 2002 to 2003, buyouts were in the middle of the boom and bust cycle, while venture capital remained in the bust cycle. This suggests that the market was shifting.
2004 to 2005 is a good time for general partners to raise and invest in venture capital funds, and for limited partners to commit capital to modest size funds.
For another approach, see: Clearlake Capital and Insight Partners
Frequently Asked Questions
What is the 80/20 rule in private equity?
The 80/20 rule in private equity refers to the idea that a small number of investments generate the majority of returns. By focusing on these high-impact opportunities, investors can optimize their strategies and allocate resources efficiently.
Sources
- https://www.wellington.com/en/insights/understanding-private-equity-performance
- https://www.plantemoran.com/explore-our-thinking/insight/2024/07/private-equitys-long-term-performance-can-make-it-worth-the-risk
- https://cepres.com/insights/private-equity-returns-measure
- https://www.chicagobooth.edu/review/private-equity-performance
- https://blogs.cfainstitute.org/investor/2024/11/08/the-tyranny-of-irr-a-reality-check-on-private-market-returns/
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