In 2020, Ludovic Phalippou published a critical article titled “The Importance of Fees in the Private Equity Realm,” addressing the study concerning what he himself labels as “An Uncomfortable Fact: Private Equity Returns and the Billionaire Factory.” This study details situations in which several Private Equity fund managers have received significantly higher personal compensations than their added value, despite achieving mediocre returns. In fact, up to 22 of them were included in Forbes’ list of the world’s 500 richest individuals.
Another section of the study examines the challenges associated with calculating the Internal Rate of Return (IRR) to evaluate fund manager performance. This calculation holds great importance, as above a preferred return threshold (typically set at an 8% annual IRR), managers receive a success fee equivalent to 20% of the profits generated by the fund exceeding said threshold. Consequently, accurate IRR calculation is crucial in determining whether a manager should receive a substantial compensation in many cases, as it assesses whether their performance is above or below the 8% threshold.
Before delving deeper into the historical returns of venture capital, it is essential to define the fundamental concepts that parameterize venture capital performance: Gross IRR, Net IRR, Net LP IRR, TVPI, and DPI.
Gross IRR The Gross Internal Rate of Return (IRR) is used to measure the profitability achieved by the fund in its investments, and its calculation is carried out as follows:
- Negative cash flows: These include investments made and related cash outflows occurring between the fund and its respective investments. This encompasses both investments in equity and debt instruments, as well as expenses directly attributable to them.
- Positive cash flows: These encompass cash inflows generated from divestments, interest, dividends, principal payment, among others, regardless of whether they have materialized or not. In the case of pending divestment positions, they are included based on their fair value on the calculation date, while other fund assets and cash are excluded. In summary, all investments, regardless of their status (held or divested), must be considered in the calculation of Gross IRR. This rate is always higher than Net IRR because it doesn’t include the following elements: fund management fees, expenses paid by portfolio companies to the fund or the management company, carried interest, and general expenses (such as legal fees, audit, and consultancy, unless specifically related to a particular portfolio company).
Net Fund IRR
The Net Internal Rate of Return (IRR) of the fund is an indicator that quantifies the profitability achieved by the fund’s investors, taking into account the following elements:
- Cash flows between the fund and its investors: This includes negative fund contributions and positive reimbursements, in addition to the corresponding portion of the fund’s remaining net assets. This encompasses the sum of the fair value of the undivested holdings, cash, and other assets and liabilities, minus carried interest. When a portfolio has been completely divested, the net IRR will reflect the investors’ profitability, deducting the following elements:
- Management fees paid to the fund’s manager.
- Carried interest of the managers.
- Other applicable expenses (except when expenses are specifically related to a particular portfolio company).
It is important to highlight that the net fund IRR represents a combination of the net IRRs of all investors. However, this can be higher or lower than the net IRR applicable to an individual investor, depending on factors such as investment dates, types of holdings, among others.
Net Investor (LP) IRR
The Net Internal Rate of Return (IRR) of the individual investor is calculated similarly to the net fund IRR, but cash flows, carried interest, and specific valuations corresponding to that particular investor are adjusted. It is important to note that this rate can only be calculated for the entire fund’s investments and not for an individual investment within the portfolio.
TVPI
Multiples allow us to make comparisons, determine, and define value in a relative and simplified manner to evaluate performance. One of these multiples is the Total Value to Paid-In Capital (TVPI), also known as the gross multiple of cost. This multiple represents the relationship between the total value of investment profitability and the initial investment. It provides insight into the fund’s performance by showing how many times the total fund value has exceeded its initial cost, i.e., how many euros have been obtained for every euro invested. This metric is intuitive as it allows users to understand how much has been obtained based on the initial investment. However, it does not consider the time value of money, as it does not account for the time required to achieve this multiple.
TVPI consists of two elements: Distributions to Paid-In Capital (DPI) and Residual Value to Paid-In Capital (RVPI). First, DPI represents the cash value and shares distributed to the fund’s investors, divided by the initial investment. On the other hand, RVPI is the residual value of the fund at a given time, i.e., the value of the fund’s investments plus other assets (such as cash, among others), minus fund obligations (liabilities and accrued carried interest), all divided by the initial investment.
DPI
The Distribution to Paid-In Capital (DPI) multiple represents the value of distributions made to the fund participants divided by the invested capital. This multiple does not take into account the time factor of investment or consider the time required for investment and divestment. Its calculation is a way of measuring the fund’s generated profitability in terms of distributions made in relation to the amount of initial capital invested, without considering the time elapsed during the investment and divestment process.
In conclusion, the precise calculation of these metrics is crucial to evaluate whether managers deserve the success fee, which is based on exceeding a specific profitability threshold. The complexity and nuances surrounding return calculations in the realm of Private Equity underline the importance of greater transparency and alignment of interests between fund managers and investors. Additionally, it is necessary to critically examine compensation structures and incentive systems to ensure that managers are rewarded fairly and proportionally to the results they achieve for investors.
Alejandro Pérez-Ochoa, Associate Closa Capital
