Top Metrics Used by Institutional Investors
Institutional investors play a crucial role in the success of private equity (PE) funds by providing the capital necessary for these funds to thrive. As such, these investors must carefully evaluate and monitor the performance of their investments. The metrics used to assess the success of private equity funds are crucial to making informed investment decisions and ensuring that capital is being allocated effectively.
In this blog, we will explore the top performance metrics used by institutional investors to measure private equity (PE) fund performance, including key indicators like IRR, MOIC, and TVPI. Understanding these metrics helps investors gauge how well a fund is performing relative to its objectives and benchmarks, manage risk, and make more informed decisions.
1. Internal Rate of Return (IRR)
What is IRR?
The Internal Rate of Return (IRR) is one of the most commonly used metrics in private equity to measure the profitability of an investment. It represents the annualized rate of return on the capital invested, accounting for the timing and magnitude of cash flows.
Why is IRR Important?
IRR is a critical metric because it helps institutional investors understand the rate of return they can expect from a fund over time. It takes into account the time value of money, meaning that it reflects the fact that capital invested early in the fund’s lifecycle will have a greater impact on returns than capital invested later. A higher IRR suggests that a fund is performing well, generating substantial returns relative to the capital deployed.
What to Look for in IRR?
Institutional investors typically compare the IRR of a fund against the required rate of return, often referred to as the hurdle rate. If the IRR exceeds the hurdle rate, it indicates that the fund is performing well. However, it's important to remember that IRR should not be evaluated in isolation; other metrics are needed to get a complete picture of a fund’s performance.
2. Multiple on Invested Capital (MOIC)
What is MOIC?
Multiple on Invested Capital (MOIC) measures the total value generated by the fund relative to the amount of capital invested. It is calculated by dividing the total value of a fund’s realized and unrealized investments by the capital invested.
Why is MOIC Important?
MOIC is used by institutional investors to determine how much value has been generated from an investment relative to the amount of money that was put in. A MOIC of 2.0 means that the fund has generated $2 for every $1 invested, signaling strong performance.
What to Look for in MOIC?
A higher MOIC indicates that the fund has delivered higher returns relative to the capital invested. However, MOIC does not take into account the timing of cash flows, which is why it’s often used in conjunction with IRR. It is especially useful for assessing the overall growth of the portfolio over time.
3. Total Value to Paid-In (TVPI)
What is TVPI?
The Total Value to Paid-In (TVPI) ratio measures the total value of a private equity investment relative to the amount of capital that has been paid into the fund by investors. TVPI includes both the residual value (unrealized value of investments still held by the fund) and the distributed value (cash that has been returned to investors).
Why is TVPI Important?
TVPI gives institutional investors a snapshot of the fund’s total performance, both realized and unrealized. This metric is useful for understanding the value that has been created so far and the potential for future distributions. A TVPI greater than 1.0 indicates that the fund has created value for investors.
What to Look for in TVPI?
TVPI is an essential metric for understanding how much value is still "on the books" of the fund. A TVPI of 1.5 would indicate that the fund has returned 1.5 times the capital invested, including both distributed returns and unrealized value. A higher TVPI suggests that the fund is performing well, with significant unrealized gains yet to be realized.
4. Distributions to Paid-In (DPI)
What is DPI?
DPI (Distributions to Paid-In) measures the amount of capital that has been returned to investors relative to the capital they have invested. This ratio is particularly important for understanding the cash-on-cash return that the fund has generated, as it focuses on actual distributions rather than unrealized gains.
Why is DPI Important?
DPI shows investors how much of their invested capital has been returned to them in cash. It is a clear indicator of how well the fund is performing in terms of delivering cash returns to investors. For institutional investors, the focus on actual cash returns (rather than just paper gains) is crucial for assessing the fund’s ability to generate real liquidity.
What to Look for in DPI?
A DPI of 1.0 means that the fund has returned an amount equal to the capital invested. A DPI greater than 1.0 means that the fund has returned more capital than it initially received, while a DPI below 1.0 suggests that the fund has not yet returned the capital invested.
5. Internal Rate of Return (IRR) to Hurdle Rate
What is the Hurdle Rate?
The hurdle rate is the minimum rate of return that the fund must achieve before it is entitled to any performance fees (or carried interest). This rate is agreed upon at the start of the investment and serves as a benchmark for measuring the fund’s success.
Why is IRR to Hurdle Rate Important?
Investors use the IRR to hurdle rate comparison to assess whether the fund has met its performance targets. If the IRR is higher than the hurdle rate, the fund is typically eligible to pay out carried interest to the general partners (GPs).
What to Look for in IRR to Hurdle Rate?
Investors want the IRR to exceed the hurdle rate by a significant margin, as this indicates that the fund has not only met its minimum return expectations but has created additional value for investors. If the IRR falls below the hurdle rate, the fund may not be eligible for carried interest, and this could be a red flag for investors.
Conclusion
The metrics discussed—IRR, MOIC, TVPI, DPI, and IRR to Hurdle Rate—are essential tools used by institutional investors to evaluate the performance of private equity funds. Each of these metrics provides a unique perspective on the fund’s performance, helping investors assess profitability, growth potential, and the likelihood of achieving their target returns.
A successful PE fund will typically exhibit high IRR, MOIC, and TVPI, along with a DPI greater than 1.0, indicating that both unrealized and realized returns are strong. Institutional investors must use a combination of these metrics to get a holistic view of the fund’s performance and make informed investment decisions.
FAQs
1. What is the most important metric for assessing private equity performance?
The most important metric can vary depending on the investor’s perspective. IRR is commonly used to evaluate the profitability of a fund, while MOIC and TVPI give insight into the total value created by the fund. DPI is important for assessing cash-on-cash returns.
2. How does DPI differ from TVPI?
DPI measures only the actual distributions (cash returned to investors), while TVPI includes both distributions and the remaining value of unrealized investments. DPI focuses on realized returns, while TVPI gives a broader view of total performance.
3. What does a high IRR indicate?
A high IRR indicates that the fund has generated strong annualized returns on the capital invested, relative to the timing and magnitude of cash flows. It is often used to compare the performance of different funds or investment opportunities.
4. Why do institutional investors focus on multiple metrics in private equity?
Each metric provides different insights. While IRR focuses on profitability, MOIC and TVPI offer a picture of total value creation, and DPI shows how much capital has been returned to investors. Using all metrics helps investors make a comprehensive assessment of a fund’s performance.
5. What should institutional investors look for when comparing PE funds?
Institutional investors should compare IRR, MOIC, TVPI, and DPI to understand the fund's potential return, risk, and ability to return capital. Comparing these metrics to industry benchmarks or peer funds can help assess the relative performance of a PE fund.