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Evaluating performance is an imperfect science: every metric has its pros and cons. Moving the goalposts, however, is rarely a sign that the game is going well. Look no further than the private equity industry, where DPI is the new IRR.
On the face of it, shifting focus towards distributions to paid-in capital over internal rates of return is bewildering given how poorly the industry is doing on both.
Private equity’s annualised IRR fell below 10 per cent in the year to March 2024, says PitchBook. That is far below the 25 per cent the industry used to aim for, and even below a rough benchmark for the cost of equity. Over the same — admittedly stonking — period, an unleveraged investment in the S&P 500 would have returned 30 per cent.
But DPIs, too, look terrible. Funds in the 2019-2022 vintage have disbursed about 15 cents on the dollar so far, according to a Goldman Sachs analysis on Preqin numbers. By this stage in the game, previous vintages had returned well over half the money invested.
There is a difference between the two measures, however. For a well-bought and well-managed portfolio, DPIs will recover over time. The heady days of 20-plus per cent portfolio IRRs are gone for good.
Both measures of performance are dinged by the temporary freeze in private equity exits. IPO markets that slam shut at the merest ruffle and trigger-shy corporate buyers means it is difficult to sell portfolio companies. That leaves little money available for distributions. Stuck companies, which don’t increase in value sharply, dilute IRRs. Poor performance and a lack of cash returned hurts fundraising, particularly for smaller, less diversified funds.
At some point, of course, there will be a thaw. When that happens, DPIs will improve. To the extent that private equity’s troubles stem from timing (rather than the quality of assets or the price at which they were acquired) end-of-fund DPI may not be far off historical average levels of 1.5 times.
IRRs — which are hugely time-dependent — do not offer the same leniency. Back-end loaded cash flows irrevocably damage end-of fund returns. On top of that, the industry model has evolved from fix-and-flip strategies to longer-term roll-ups and industrial turnarounds. Vertiginous growth rates are hard to keep up over longer periods, which puts industry IRRs under inevitable pressure.
Investors — increasingly desperate to see some cash back — are themselves more focused on DPIs, correctly given that cash in hand is worth more than an unrealised IRR in the bush. To the extent that this increases the pressure on private equity funds to capitulate, cutting pricetags to get assets out the door, it will harm longer-term performance — whatever the measure used to evaluate it.