In the complex world of private-equity investments, understanding returns can be challenging compared to more transparent asset classes like bonds or publicly traded stocks. While the latter requires simple current and past price comparisons, private equity involves a maze of measurements and sporadic cash flows, making it less straightforward.
Investors, typically large institutions such as pension funds and university endowments, rely on a variety of performance metrics supplied by private-equity firms. Among these, the internal rate of return (IRR) and the multiple of money (MoM) are popular, yet each has its drawbacks, especially considering they may include flattering private valuations or ignore significant costs like capital expenses. However, a more reliable indicator, Distribution to Paid-In (DPI) capital ratio, has gained prominence. DPI measures cash distributions as a share of the cash investors have committed, offering a hard-to-manipulate gauge that accounts for the substantial fees associated with these funds.
Historically, private equity has been a lucrative field, with firms distributing about 25% of fund values back to investors annually over the last 25 years. But recent shifts in the market have seen these figures tumble dramatically. According to Raymond James, an investment bank, distributions in 2022 fell to just 14.6% and dropped further in 2023 to a low of 11.2%, marking the weakest performance since the 2009 financial crisis.
The decrease in DPI can be attributed to rising interest rates and declining equity valuations, which deter private equity managers from selling assets in unfavourable market conditions. Furthermore, traditional exit strategies, like initial public offerings or acquisitions, have nearly stalled, echoing the investment droughts that followed major market disruptions such as the dotcom bust and the 2008 financial meltdown.
However, the impact of these lean times is more pronounced now due to the increased reliance on private equity by pension funds, which depend heavily on such distributions to fulfil financial obligations to retirees. Moreover, the investment landscape has shifted, with fewer opportunities for bargain purchases that typically follow market downturns, compounded by high interest rates that hamper financing arrangements.
Despite these challenges, there could be a silver lining if stock markets continue their upward trajectory, potentially improving valuations in private markets and revitalizing exit opportunities for private equity. Nevertheless, much of the current market buoyancy is driven by the tech sector, particularly with excitement around artificial intelligence, areas where private equity is less invested compared to sectors like healthcare and home maintenance.
The road ahead for private equity remains uncertain. While the potential for recovery exists, worlwide inflation persists, suggesting continued high interest rates which could further complicate the financial landscape. Investors remain on edge, understanding that only time and market dynamics will reveal when they can expect robust cash distributions once again.
Josep Ma Romances, President and Founder of Closa Capital.
