Institutional Investors

The annualised internal rate of return (IRR) and money multiples are the two most commonly used measurements of private equity and venture capital performance.

IRR calculates the returns by looking at all of the cash flows from the investment into a fund over a given period, taking into account drawdowns, distributions such as capital gains and income through dividends, and a valuation if the fund still has residual value.

Money multiples are an alternate metric that is often used and provide a useful additional measure alongside IRRs when comparing the relative performance of funds. Multiples provide a cash-on-cash measure of how much investors are receiving, and are calculated by dividing the value of the returns by the amount of money invested.

Both these measures have their strengths and weaknesses and other methodologies can be used, such as the Public Market Equivalent, which allows investors to more accurately compare performance between private equity and the public market. For publicly quoted equities and bonds which have clearly defined and often liquid markets, the returns are easily accessible, frequently in realtime, and easily understood. Private equity and venture capital, however, is somewhat different and reflects the irregularity in the timing and discretionary nature of the cash flows between the fund and LPs.

For more information about the different types of private equity fund measurement please Performance Measurement Survey report here.

High-quality reporting is a vital instrument in helping to keep the private equity industry one that is both transparent and meets investors’ needs. Reporting requirements, including frequency, accounting standards and audit requirements are agreed upfront with investors, usually in the Limited Partner Agreement. While there are a number of sources of guidance, in practice fund reporting varies as it is tailored to the specificities of the fund and investor requirements. Reporting to investors is usually comprised of a letter or report from the firm detailing the fund’s activities and performance, financial information including a calculation of net assets, and other performance metrics and supplementary information.

Due to the long-term nature of private equity investments, it can take time for investors to see the final realised return on their commitments. When providing interim reports to investors, many firms will reference the International Private Equity and Venture Capital Board’s (IPEV) valuation guidelines. These provide practical guidance and ensure that firms adopt consistent and appropriate valuation methodologies. They outline the main valuation techniques that have helped increase the transparency of the industry, as well as confidence in the interim fund net asset values that the firms report.

Private equity and venture capital, as with most actively managed asset classes, involves a fee structure, both to meet the day-to-day operational expenses of a fund manager and to incentivise the fund manager to achieve the best possible return for an investor.

Management fees allow the fund manager to meet their own operating costs, including salaries for the team and regulatory compliance.

Carried interest is used to describe the fund manager’s performance-related share of realised profits from investments – typically 20% – after the investors have achieved a certain level of returns. As carried interest is only allocated after investments are realised, it incentivises private equity firms to focus on operational improvements and the long term realisation prospects for an investment.

A study conducted Montana Capital Partners found the risk for a diversified portfolio is extremely low for an investor who is able to hold their assets to maturity. Not only can capital calls and distributions be forecasted accurately, but the probability of losing the invested capital or the already accrued book value at any given time is very low. As such, these results indicate that the risks of private equity are manageable and that the asset class offers attractive returns, adding to the overall diversification across the whole portfolio for institutional investors. The study can be found here.

Recent years have seen significantly more emphasis placed on the responsible investment agenda within the private equity community. This agenda encourages investors to better evaluate the environmental, social and governance (ESG) implications of their decision-making, both in areas they directly control and also in areas over which they can exert a strong influence.

In the marketplace, ESG issues can have a real impact on business value and investment risk, and a well-founded approach to these issues can be a means by which private equity firms and portfolio companies can balance risks, create opportunities and, ultimately, differentiate themselves from their competitors.

Many private equity firms have already recognised the value of ESG initiatives not only in achieving environmental and social change, but also in reducing costs and minimising risks, and many already consider certain ESG issues during pre-acquisition due diligence, particularly compliance and potential ESG-related liabilities, while others are working towards a more structured and strategic approach under an overarching sustainability strategy, linked to the firm’s business strategy.

It has been widely recognised within the industry as a whole that implementing and maintaining ESG strategies during the investment and ownership periods can have a positive impact upon exit.

Although the market is still young and firm quantified data on the financial impact of strong ESG performance is not widely available, it is believed that a positive GP and portfolio company attitude towards ESG issues, translated into improved ESG performance, can result in higher exit prices.

The UN Principles of Responsible Investment (UNPRI) form private equity’s primary framework, providing a voluntary and aspirational structure for the incorporation of ESG considerations into investment decisions. Today, over 1000 asset owners and investment managers, including many BVCA members, are signatories to the UNPRI.