PRIVATE EQUITY VALUATION

The costs associated with private equity investments are much more significant than the cost of
investing in public companies. Costs of investing in private equity can be broken down into:

t
Transaction fees. These include costs of due diligence, bank financing costs, and legal
fees for acquisition and sale transactions in portfolio companies.
t
Investment vehicle fund setup costs. These include legal costs of setting up the investment
vehicle (e.g., limited partnership, company limited by shares) and are amortized over the
vehicles life.
t
Administrative costs include custodian, transfer agent, and accounting costs and are
usually charged as a percentage of the funds net asset value.
t
Audit costs are fixed annual charges.
t
Management and performance fees for PE funds are typically higher than that for plain
investment funds. In the private equity industry management and performance fees are
around 2% and 20% respectively.
t
Dilution. Shareholders suffer dilution of their equity interests in portfolio companies from
additional rounds of financing and from stock options granted to management.
t
Placement fees. These are charged by placement agents who raise funds for PE firms.
Placement fees may be charged upfront (usually 2%), or as trailer fees that are charged
annually as a fraction of the amount invested by limited partners, as long as the amount
remains invested.

LOS 40h: Interpret and compare financial performance of private equity funds
from the perspective of an investor. Vol 5, pp 161164
Evaluating Fund Performance
The performance of a private equity fund may be evaluated using either the internal rate of return
(IRR) or a multiplesbased approach.
Internal Rate of Return (IRR)
IRR is a cashweighted (or moneyweighted) return measure that accounts for the time value of
money. IRR is the recommended measure of private equity performance according to the Global
Investment Performance Standards (GIPS) and other venture capital and private equity standards.
However, in a private equity setting, the IRR should be interpreted with care because it assumes
that interim cash flows are reinvested at the IRR, whereas NAV is primarily illiquid for most of a
PE funds life. IRR may be calculated gross or net of fees (management fees, carried interest, etc).

t
Gross IRR relates cash flows between the private equity fund and its portfolio companies.
It is therefore, a relevant measure for evaluating the PE firms ability to create value.
t
Net IRR relates cash flows between the private equity fund and LPs and is therefore, a
relevant measure of return to investors.

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Multiples
Multiples simply measure the total return to investors relative to the total amount invested.
Although they ignore the time value of money, multiples are popular among the LPs because
of their simplicity and ability to distinguish between realized returns (proceeds from actual
successful exits) and unrealized returns (based on the GPs estimates of NAV).
Quantitative Measures of Return
The most commonly used multiples are:

t
PIC (paid-in capital): Ratio of paid-in capital to date to committed capital.

This ratio measures the proportion of committed capital called by the GP thus far.
t
DPI (distributed to paidin) or cashoncash return: Value of cumulative distributions paid
to LPs as a proportion of cumulative invested capital.
It is a measure of the funds realized return on investment.
DPI is typically presented net of management fees and carried interest.
t
RVPI (residual value to paidin): Value of LPs shareholdings held with the fund as a
proportion of cumulative invested capital.
It is a measure of the PE funds unrealized return on investment.
The value of portfolio holdings is determined by the GP.
RVPI is also typically presented net of management fees and carried interest.
t
TVPI (total value to paidin): Value of portfolio companies distributed (realized) and
undistributed (unrealized) value as a proportion of cumulative invested capital.
TVPI equals the sum of DPI and RVPI.
It is also typically presented net of management fees and carried interest.
Qualitative Measures
In addition to the quantitative measures of return, the following qualitative aspects should also be
analyzed:

t
Investments realized since inception. All successes and failures should be evaluated.
t
Unrealized investments. Troubled portfolio companies should be identified and the
expected time to exit should be estimated for each portfolio company.
t
Cash flow forecasts for each portfolio company and for the overall portfolio.
t
Portfolio valuation, NAV, and audited financial statements.
For example, consider a fund that follows a venture capital strategy in tech companies. This fund
had a vintage year of 1999 and a term of 10 years. Five years into its life (midlife) the fund had a
DPI of 5% and a RVPI of 52%.
The TVPI of 57% indicates that the Jcurve for this fund will probably be extended. The fund
is halfway into its life and LPs total return (realized and unrealized) is still well short of
committed capital. Further, the bulk of the return is unrealized (as RVPI is significantly greater
than DPI) which suggests that the fund has been unable to harvest many of its investments. Given
that the fund was formed just before the Internet bubble burst in 2000, we can infer that exit
opportunities must have diminished and the fund may have had to write off some investments.

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In this situation, the LPs should carefully evaluate existing companies in the funds portfolio and
carefully scrutinize the GPs valuations of those companies to ensure that they are not inflated
given the bleak outlook for the technology sector. See Example 5-1.
Example 5-1: Comparing Private Equity Fund Performance
An analyst gathered the following information regarding two private equity funds:

Fund
Fund A
Fund B

Gross
IRR
18.4%
2.1%

Net
IRR
12.1%
0.2%

DPI
1.21
0.26

RVPI
1.35
1.08

TVPI
2.56
1.34

Performance
quartile
1
2

Maturity
of fund
7 years
3 years

Compare the performance of the two private equity funds.

Solution:
Based on the information given, we can infer the following regarding the two funds:
Fund A:
t
It has so far returned $1.21 to LPs for every $1 of capital drawn down.
t
Its RVPI of 1.35 indicates that the fund is expected to offer a substantial return at
termination when it harvests its investments.
t
The gross IRR of 18.4% and net IRR of 12.1% after 7 years also represent good
performance.
t
The fund ranks in the first quartile, which implies that it belongs to the best performing
funds of that category and vintage year.
Fund B:
t
It is a less mature fund than Fund A.
t
Its gross IRR of 2.1% and net IRR of 0.2% indicate that it is still experiencing the
Jcurve effect.
t
A DPI of 0.26 indicates that the funds realized returns are not yet substantial. However,
the RVPI of 1.08 indicates that despite the fact that it is only 3 years old, the fund has
made some fairly profitable investments.
Benchmarks
The IRR of a particular PE fund should be compared with the median IRR for the peer group of
comparable PE funds that have a similar investment strategy and vintage year. This is because
PE returns follow clear trends over time, with some vintage years performing much better than
others.
Analysts must also be careful when comparing the performance of private equity to that of other
asset classes. This is because PE funds are usually measured using the IRR (which is a money
weighted return measure), while the performance of most other asset classes is measured in terms
of timeweighted rates of return. One solution is to calculate the moneyweighted rate of return
for benchmark equity indices using the cash flow patterns of PE funds. Unfortunately however,
this technique suffers from significant limitations.

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LOS 40i: Calculate management fees, carried interest, net asset value, distributed to
paid in (DPI), residual value to paid in (RVPI), and total value to paid in (TVPI) of a
private equity fund. Vol 5, pp 161164
Example 5-2: Calculating Performance Measures
Gamma Fund has committed capital of $250 million. The general partner (GP) of the fund is paid carried
interest of 20% if the funds NAV before distributions exceeds committed capital. Further, the fund
charges a management fee of 3% of paidin capital. The following table provides information regarding
the funds capital calls and performance for the first 7 years of its life.
Year
1
2
3
4
5
6
7
1.
2.

Capital Called Down

70
50
30
20
20
10
10

Operating Results
30
20
5
70
80
100
155

Distributions

40
80
120

Calculate paidin capital, management fees, NAV before distributions, carried interest, and NAV
after distributions for each of the 7 years.
Calculate the funds DPI, RVPI, and TVPI at the end of 7 years.

Solution:
Capital
Called Paidin
Years Down Capital

1
2
3
4
5
6
7
1.

70
50
30
20
20
10
10

Management Operating
Results
Fees

70
120
150
170
190
200
210

2.1
3.6
4.5
5.1
5.7
6.0
6.3

NAV before
Distributions

Carried
Interest

37.9
64.3
94.8
179.7
274.0
333.2
400.1

0.0
0.0
0.0
0.0
4.8
11.8
13.4

30
20
5
70
80
100
155

Distributions

NAV after
Distributions

40
80
120

37.9
64.3
94.8
179.7
229.2
241.4
266.7

Paidin capital (PIC) simply equals the cumulative amount calleddown. For example:
PIC (Year 6)

70

50

30

20

20

10

$200m

Management fees for each year are calculated as 3% of PIC. For example:
Management fee (Year 6)

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3%

$6m

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NAV before distributions

Prior years NAV after distributions Capital called

down Management fees Operating results

NAV before distributions (Year 6)

229.2

10 6

100

$333.2m

The GP starts earning carried interest once the funds NAV exceeds committed capital
($250m). This occurs in Year 5, when the funds NAV before distributions equals
$274m. Therefore, carried interest will be paid as 20% of the excess.
Carried interest (Year 5)

( 274 250)

20%

$4.8m

Carried interest in each subsequent year will be paid on the increase in NAV before
distributions over the year.
Carried interest (Year 6)
NAV after distributions

( 333.2 274 )

$11.8m

NAV before distributions Carried interest Distributions

NAV after distributions (Year 6)

2.

20%

333.2 11.8 80

$241.4m

DPI is the value of cumulative distributions paid to LPs as a proportion of cumulative

invested capital.
DPI
DPI

Cumulative distributions / PIC

(40 80 120) / 210 1.1429

A DPI greater than 1.0 indicates that LPs realized return already exceeds the amount
they invested in the fund.
RVPI equals the value of LPs shareholdings held with the fund as a proportion of
cumulative invested capital.
RVPI
RVPI

NAV after distributions / PIC

266.7 / 210 1.27

TVPI equals the sum of DPI and RVPI.

TVPI

DPI

RVPI

2.4129

The TVPI indicates that when realized and unrealized returns are combined, LPs
should expect to earn almost 2.5 times their investment in the fund once all the funds
investments have been harvested.

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