Unstable Measures Cause Unreliable Conclusions
Performance metrics like IRR and TVPI have a magnetic pull for most private equity investors. Their allure is obvious: a simple number that summarizes performance in practical terms and, at least theoretically, allows for direct comparison among different funds. These ratios are also provided “out of the box” by the leading fund database providers, making them easy to use in screening and due diligence.
At the same time, fund selectors and consultants realize that these measures have serious drawbacks. Anyone who has played around with a DCF model knows that the output can be wildly sensitive to small changes in inputs around discount rate and cash flow timing. Likewise, private equity IRRs rely on a number of questionable assumptions, notably related to the GP’s reinvestment rate and the LP’s opportunity cost of capital. The lack of a standardized calculation method can also lead to comparability issues between managers.
Money multiples such as TVPI obviate some of these issues, but at the cost of not considering the time value of money. Furthermore, they cannot be accurately calculated until a fund is wound down. This delay is a serious issue because often, private equity firms will raise new funds from investors before the final results of previous ones are available.
Perhaps most seriously, these metrics do not account for risk. Financial leverage can be present at both the fund and the underlying operating company level, and each fund’s acquired business portfolio has a unique risk profile. As absolute measures, they also do not compare performance to the broader opportunity set available to the investor.
Given these challenges, asset allocators should not assign undue weight to these metrics when screening for potential investments or evaluating PE manager skill. Because IRRs can change significantly from year to year and depending on the methodology used, premising due diligence decisions upon them can result in sub-optimal results.
Toward More Robust Performance Metrics
Empirically’s approach to private equity performance evaluation is based on the concept of a public market equivalent (PME). Investing in private equity entails accepting illiquidity, valuation uncertainty and idiosyncratic risk, so prospective investors must verify that these downsides are adequately compensated in the form of superior risk-adjusted returns. Specifically, a private equity fund’s performance should be compared to a liquid alternative which is representative of the private equity manager’s opportunity set as well as adjusted for differences in capital structure.
While common screening tools are beginning to implement PME approaches, they are presented relative to broad benchmarks such as the S&P 500, which are not usually meaningful since they differ so much from the risk and reward parameters of the private equity manager. Producing a robust comparison involves creating and calculating a custom benchmark for each fund, and so it isn’t possible using off-the-shelf screening tools. While this may sound daunting, our technology can accomplish this at scale in an objective and transparent way, relying only on input data that is already commonly available.
To take the PME to the next level, Empirically can perform two additional types of simulations:
- Utilize our investment strategy simulation engine, EPSE, to generate a probability distribution of returns that would be achieved by active managers facing the liquid alternative opportunity set. This allows not only a point comparison of the private equity manager’s realized return to the PME return, but also a view of the manager’s position on the distribution. In other words, it answers the question of how difficult it would have been to achieve as good or better results in the public market.
- Utilize our database of corporate actions – including publicly-disclosed transaction multiples – to simulate the M&A environment that prevailed during the private equity fund’s lifetime. This facilitates a decomposition of to what extent realized results were attributable to favorable or unfavorable changes in the external environment (i.e. market valuations), versus the impacts of leverage, versus imputed skill of the private equity team.
These approaches have the advantage of resulting in a clear, easy-to-interpret summary measure similar to familiar metrics like IRR, while being grounded in a much stronger analytical foundation.
We invite you to schedule a demo to learn more about how these simulatioouns can be used as part of a diligence process to triangulate GP quality with greater accuracy.
Regardless of whether they choose to use a PME approach such as ours, prospective investors should seek as much detail as possible on the underlying investments made by a private equity team. Studying the investments can provide much more information than is captured in a summary IRR or money multiple metric. In particular, investors should seek to understand the sources of returns in each transaction:
- Buying and selling at opportune times (multiple expansion)?
- Operating improvements (EBITDA growth/margin expension)?
- Use of leverage?
Based on these transaction-level insights, particularly related to the presence or absence of consistent patterns in value creation across transactions and funds, judgments can be made about the nature of a private equity team’s skill, and its likelihood of persisting in the future across different time periods and objectives.
Author Information: Jordan Boslego is a Partner at Empirically.