Investors look beyond IRR, investment multiple

The focus on distributions stems in part from the experience of investors during the financial crisis. Portfolio markdowns didn’t always keep pace with market reality in those dark days; that led many investors to lose faith in the interim valuations assigned by sponsors to their portfolio companies. Some investors also ended up under-estimating the pace of distributions, which in some cases put at risk their ability to meet capital calls.

The head of investor relations at one buyout shop in the market with a fund this year said that prospective investors this time out cared most about distributions-to-paid-in multiple (DPI), or cash or shares returned divided by cash drawn down. That was followed in importance by two measures that do rely on interim valuations, he said—investment multiple, or the total-value-to-paid-in multiple (TVPI), and then internal rate of return (IRR), a discount rate that equates the present value of cash outflows to cash inflows in a fund.

“‘You can’t eat IRRs’ is a line I heard on the road a lot this time,” this executive told Buyouts, adding that fundraising didn’t really click for the firm until it scored several recent realizations. “Investors are clearly waiting to see the outcome of your investments more-so than they were before.”

Meantime, investors are also seeking out sophisticated ways to measure the amount by which sponsors beat benchmark public equity indexes, such as the S&P 500. For years many institutional investors have set as their private equity benchmark beating by a few hundred basis points the S&P 500 or similar index. Their reasoning: you shouldn’t have to put up with the industry’s illiquidity, high costs and other drawbacks unless you’re generating a premium to what you could realize in public equities.

But investors haven’t necessarily had a mathematically sound way to measure outperformance. The easy-to-grasp compounded annual rate of return achieved by an S&P 500 index fund, for example, does not compare neatly to the IRR generated by a private equity fund. The complex IRR calculation is highly influenced by early wins and losses and makes assumptions about the return generated by idle cash that not everyone agrees with.

More than 20 years ago Austin Long, founder of consulting firm Alignment Capital Group, and Craig Nickels, today head of U.S. fund investments in the private equities department of Abu Dhabi Investment Authority, developed for the University of Texas Investment Management Company what became known as the first public market equivalent (PME) method of comparing private and public equity performance. This calculation involves mirroring the cash flows of a private equity fund with that of an index fund like the S&P 500—buying the index when cash is drawn down, selling when cash is returned. At any point you can calculate the IRR of both the private equity fund and its mirror public market equivalent, then in theory make an apples-to-apples comparison.

PME is not a perfect solution, however. In part that is because the calculation tends to break down when the private equity fund substantially outperforms its public equity benchmark. It is also subject to the same flaws as the IRR calculation on which it is based. Over the past two decades advisers and academics have worked to improve PME and related calculations. While none is free from flaws, they seem to be catching on with investors and sponsors.

David Fann, president and CEO of TorreyCove Capital Partners, an adviser to Oregon Investment Council and other big investors, said his firm has been using PME-related measurements for at least the last five years. In the wake of the financial crisis, Fann said, a lot of limited partners questioned whether they would have been better off investing in public equity index funds. PME analysis helped demonstrate to clients that private equity delivered returns “well in excess” of public markets, Fann said.

Below are highlights of the major developments in PME and related calculations over the years, several of them outlined in a draft academic paper co-authored by Oleg Gredil, a PhD student at the Kenan-Flagler Business School of the University of North Carolina, Barry Griffiths, vice president in the quantitative research team at secondary buyer Landmark Partners, and Rüdiger Stucke, a research fellow at the Saïd Business School at the University of Oxford.

* Around 2003 adviser Capital Dynamics introduced PME+, which adds a scaling factor to the PME distributions to fix some of the flaws in the Long-Nickels calculation, according to the paper. Rival Cambridge Associates came up with its own twist on PME, called modified PME, which also adds a scaling factor to distributions. While Cambridge Associates has been using mPME for years, the firm this year began publishing mPMEs as part of its quarterly private equity index and benchmarks report. (Capital Dynamics filed a lawsuit in early November accusing Cambridge Associates of infringing on a 2010 patent in developing its mPME method—see related story, this issue.)

* In 2005 Steven Kaplan, professor at the University of Chicago Booth School of Business, and Antoinette Schoar, professor at the MIT Sloan School of Management, developed a version of PME that looks at the ratio of wealth creation in a private equity portfolio with that of a matching public equity portfolio. Any number above one indicates the private equity portfolio outperformed; a PME of 1.2, for example, suggests an outperformance of 20 percent. The so-called Kaplan-Schoar PME avoids using IRRs, and therefore sidesteps the problems associated with them. However, according to the Gredil draft paper the Kaplan-Schoar PME “gives no information about the rate at which the excess wealth has accrued.”

* Building on his early 1990s work on PMEs, Alignment Capital’s Long has continued to develop new tools to evaluate the performance of the private equity portfolios of his state pension fund clients. Specifically, he has been using a technique called “bootstrap sampling” to compare how an investor’s portfolio has performed relative to thousands of randomly-generated portfolios of private equity funds, as well as their public-equity equivalents. Long said he’s also developed a patented technique to derive the risk in a private equity portfolio relative to a public equity index; the measurement of risk in private equity promises to be an area of much research and debate in coming months.

* A year and a half ago, Oliver Gottschalg, an associate professor at the HEC School of Management in Paris, founded a company called PERACS to market a variety of benchmarking tools that, like the Kaplan-Schoar PME, avoid IRR calculations. Gottschalg’s method is based on determining a profitability index for each private investment, or the ratio of the present value of distributions over the present value of capital calls using an MSCI global stock market index as a discount rate. The difference between the profitability index and the investment multiple shows the level of outperformance over public equities; it can then be converted into an annualized rate of value increase that takes into account the duration of individual investments. Sponsors pay anywhere from $30,000 up to more than $100,000 per year to subscribe to the PERACS service, which helps them identify the source of outperformance or underperformance. Early clients include Clayton, Dubilier & Rice, Doughty Hanson & Co, Kohlberg Kravis Roberts & Co, Nordic Capital andPermira.

* Along with surveying the development of PMEs, Gredil, Griffiths and Stucke in their paper introduce what they describe as a ”novel approach” to measuring excess returns generated by sponsors over public equities. Their “Direct Alpha” measurement is closely related to the Kaplan-Schoar PME, and takes it one step further by directly computing the annual rate of outperformance of private equity over a public index.

Are investors clamoring for PMEs, profitability indexes and related measurements? Sponsors in fundraising mode say no, although some have started pro-actively using them to demonstrate their investment prowess.

Michael Elio, managing director-industry affairs at the Institutional Limited Partners Association, believes the publication of mPMEs by Cambridge Associates starting with the second quarter is significant. ”If a major provider is doing it, guess what? It’s now mainstream.”