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The Application and Extension of Digital Twins for Investor Education: Understanding the Evaluation Methods of Private Equity Fund Investment Performance

2023/08/25

An investment in a private equity fund can be seen financially as an investment in a chain of cash flows generated by the underlying portfolio company, which is very different from interest-paying bonds. Bonds generally have cash outflows at the beginning of the period, and the timing and amount of cash inflows can be predicted more accurately according to the terms of the bond contract. For private equity funds, the timing and amount of cash flow is very uncertain.

According to the fund partnership agreement, the GP can issue a capital contribution request to the investor during the investment period of the fund, on the other hand, the investor's committed funds may not be used in full. Similarly, the specific allocation time and amount of fund investment income allocated by GP to investors depends in many cases on the market and the investment situation of the project, and it is difficult to predict in advance. Moreover, the largest cash inflows generally occur at the end of the life of the fund. Therefore, how to accurately measure the investment performance of private equity funds is a difficult topic.

To analyze the historical performance of a fund, the most important thing to look at is two indicators, the overall return multiple and the internal rate of return. If the size of a fund is 5 million yuan, and the fund ends after 5 to 7 years, how much money will be returned to investors, 15.20 billion or <> billion? This is real, not that he may take the money to smash a star project and lose everything else.

Under the premise of the overall return multiple, you also have to calculate its compound rate of return, because money has time value, he earns you 10 times the money in 3 years, he earns you 5 times the money in 3 years, which is not the same, so these two comprehensive indicators: the overall return multiple and the internal rate of return (IRR) are the two most important indicators.

In practice, there are two commonly used methods for evaluating the investment performance of private equity funds:

Investment Multiple

Internal Rate of Return

The discount rate at which the present value of the LP's total capital contribution is equal to the present value of all future cash receipts

Return multiplier method

Overall returns are usually measured in terms of "return multiples".

Return multiples are perhaps the most common way to evaluate the investment performance of private equity funds. It is calculated by dividing the return value of a private equity fund by the amount of money invested in the fund, which is the ratio of "income to investment". Add financial module-assistant WeChat: X101Y101 to obtain a series of courses and materials on the practical operation of financial dry goods.

For example, if the fund income is 2 times the invested funds, the fund return multiple is 2.

In practice, there are generally three types of measurement methods for return multiples, and their focus will be different.

1. Distributed Value to Paid-in Ratio

2. Residual Value to Paid-in Ratio

3. Total Value to Paid-in Ratio

* Actual investment funds are the paid-up funds of LP, which are part of the LP's committed funds, which are used to invest, pay management fees and other fund-related expenses.

Of course, the biggest flaw of the multiplier method is that it does not take into account the length of time the money is invested in the fund. For example, with the same 3x return multiple, one investment takes 10 years to get a return, and the other only takes 2 years to get the same return multiple, their investment efficiency is obviously different.

In addition to not taking into account the time value of money, the return multiple method does not indicate to LPs the potential risks and whether the return on investment from early exits will be reinvested.

Return multiples are perhaps the most common way to evaluate the investment performance of private equity funds. It is calculated by dividing the return value of a private equity fund by the amount of money invested in the fund. This "income to investment" ratio is simple and easy to interpret. For example, if the fund's income is 2 times the amount invested, the fund's return multiple is 2.

There are generally three types of measures of return multiples:

1. Distributed Value to Paid-in Ratio

2. Residual Value to Paid-in Ratio

3. Total Value to Paid-in Ratio

☆ The actual investment fund is the paid-up funds of the LP, which is part of the LP's committed funds, which are used for investment, payment of management fees and other fund-related expenses.

DVPI (Allocated Value / Real Investment Ratio)

DVPI, also known as the Realized Multiple, is a measure of the ratio between the return an LP receives and the amount of money it puts into the fund.

DVPI is often used to measure the performance of funds that are about to close. It shows the net value of the fund's investment performance relative to all the money invested. Here the LP invests funds including the part paid to the fund management (management fee and profit share) and the part invested in the target company. It is important to note that DVPI does not provide a good indicator of the fund's investment performance if its committed funds have not been fully invested (i.e. at the beginning of the fund's lifetime).

RVPI (Salvage Value/Real Investment Ratio)

RVPI, also known as the "Unrealized Multiple", measures the net asset value of a private equity fund, or "unrealized income," relative to the amount of money LPs put into the fund.

This ratio reflects the fund's revaluation of the portfolio company, i.e. the total valuation of all outstanding projects in the fund relative to the total amount of money invested by the LP at that time. This indicator is often used for funds that have not yet returned much money and are in the early stage of their existence. This measurement largely depends on how the fund values its portfolio companies, and if the fund adopts a conservative bookkeeping approach to its portfolio companies, this measurement may yield a very low return multiple, which can be misleading.

TVPI (Total Value/Real Investment Ratio)

TVPI is the ratio of the present value of all remaining investments in the fund plus the total value of all investment allocations in the current period to the total amount of funds actually invested. In other words, the sum of DVPI and RVPI.

TVPI may be the current measure of the fund's investment performance relatively well until the end of the fund's life period.

Flaws and solutions of the return multiplier method

Flaw:

The main drawback of the return multiple measurement method is that it does not take into account the length of time the money is invested in the fund. For example, with the same 3x return multiple, TVPI cannot distinguish between an investment that takes 10 years to get a 3x return and another that takes only 2 years to get the same return multiple. In addition to not taking into account the time value of money, the return multiple method does not indicate to LPs the potential risks and whether the return on investment from early exits will be reinvested.

Internal rate of return

The most intuitive understanding of internal rate of return, or IRR, is to think of it as a fixed interest rate equivalent over the life of the fund. At this rate, the investor's committed funds must be invested to earn the expected cash income.

Generally, IRR calculations, excluding management fees and carried interest, reflect the investor's net return.

Calculation of IRR:

The IRR calculated when the fund has not been liquidated during the life of the fund is called interim IRR. Medium-term IRR is the present value of the LP's total capital contribution, a discount rate equal to the sum of the present value of all cash receipts and the present value of the unrealized portfolio. When the fund is liquidated, the terminal IRR, which is the present value of the LP's total capital contribution, can be calculated, equal to the present value discount rate of all cash income over the life of the fund.

Generally, the medium-term IRR fluctuates up and down around the terminal IRR until the fund terminates. Interim IRR performance gives an idea of the performance of a private equity fund before liquidation, but end-term IRR is only available after the fund is liquidated.

Disadvantages of the internal rate of return method:

The calculation of IRR is very sensitive to the timing of cash flow. Both private equity funds with 10-year investment horizons may have the same return multiple, but generate different IRRs. Funds with earlier cash allocations have a larger IRR value. For example, some fast-forward and fast-out projects may have an IRR of more than 200%, but the actual return multiple is less than 2 times.

Therefore, when measuring the investment performance of private equity funds, LPs evaluate both IRR and return multiples. In the early years of the fund's existence, IRR fluctuates greatly, and the return multiple may be more indicative. However, since IRR includes the time value of funds relative to the return multiple, it also more fully reflects the return received by the LP.

The most intuitive understanding of IRR is to think of it as the equivalent fixed interest rate for the life of the fund. At this rate, the investor's committed funds must be invested to earn the expected cash income. Generally, IRR calculations, excluding management fees and carried interest, reflect the investor's net return.

Calculation of IRR

Generally, the medium-term IRR fluctuates up and down around the terminal IRR until the fund terminates. Interim IRR performance gives an idea of the performance of a private equity fund before liquidation, but end-term IRR is only available after the fund is liquidated.

Flaws and solutions of the internal rate of return method

Flaw:

GPs often use IRR as a measure of historical performance when raising new funds, and IRR's sensitivity to the timing of cash flow income distribution has prompted GPs to improve IRR through immediate cash management, such as exiting early-stage investment projects earlier and reinvesting exit funds.

Workaround:

When measuring the performance of a private equity fund's investments, LPs evaluate both IRR and return multiples. In the early years of the fund's existence, IRR fluctuates greatly, and the return multiple may be more indicative. However, since IRR includes the time value of funds relative to the return multiple, it also more fully reflects the return received by the LP.

Other assessment methods

In addition to the multiple of return and internal rate of return methods, other methods that can be used to assess the performance of private equity funds include the net present value (NPV) method.

This measurement method has certain difficulties in practical application. On the one hand, the calculation of net present value requires assumptions about the cost of funds, the size of which varies from private investor to private investor. At some level, a fund's minimum return on capital can be used as a fixed discount rate, and performance comparisons can be made if different funds use the same minimum return on capital. On the other hand, NPV is scale-dependent, so this method cannot be used directly for funds of different sizes.

In summary, the above several evaluation methods to measure the investment performance of private equity funds have their own advantages and disadvantages, and in practical application, one evaluation method will not be used alone, but a combination of the above methods. It should also be noted that the fund's book return may be inflated due to factors such as the overvaluation of the subsequent financing of the invested company or the overly optimistic GP expectations. And the final return that is actually realized when the fund is exited is what matters.

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