Private equity is capital invested in companies not listed on a stock exchange or publicly traded. Private equity funds buy public and private companies with the goal of increasing their value over a number of years before selling them.
Private equity funds typically have a finite term of 10 years or more, though their average company holding period is closer to five years. Private equity investments are illiquid: exiting them early can be difficult, and they can take years to deliver returns.
Private equity funds have typically required an investment of at least $25 million from institutions and high net worth individuals, but some have recently dropped the minimum to as little as $25,000 for accredited investors and qualified clients.
The industry's specialized function and complicated structure have led it to develop a professional jargon that outsiders may find hard to understand.
Key Takeaways
- Private equity firms raise funds that buy companies and aim to increase their value over a number of years before exiting the investment.
- The industry has developed specialized terms to set the compensation of private equity fund managers and evaluate fund performance.
- Carried interest is a share of fund returns accounting for the bulk of private equity managers' compensation. It is usually taxed as a long-term capital gain rather than income, which would incur a significantly higher marginal tax rate.
- The hurdle rate, or the preferred return, is the minimum return limited partners must earn before the general partner can collect carried interest.
- Ratios such as the investment and realization multiples are used by private equity firms to present fund performance to prospective investors.
Private Equity-Speak 101
Before discussing the ratios most commonly used in private equity, let's go over some of the basic terms. Some are used only in private equity while others may be familiar depending on your exposure to alternative assets, such ashedge funds.
Limited Partners
A private equity's limited partners are its clients—the investors who contribute capital and pay the management fees. They are protected from losses beyond the funds invested as well as from any legal actions taken against the fund or its companies.
General Partner
A general partner is an entity, typically a partnership, that manages a private equity fund and its investments. General partners have typically earned management fees of 2% of fund assets as well as a share of fund profits called carried interest, often set at 20% but ranging from 5% to 30%. General partners, in turn, can pass along a share of the carried interest they earn to the individual asset managers.
Carried Interest
Carried interest accounts for the bulk of private equity fund managers' compensation. It is calculated as a share of fund profits, historically 20% above a threshold rate of return for limited partners.
In contrast with most other forms of employment compensation and business income, carried interest earned from fund investments held for at least three years is taxed as a long-term capital gain at a rate below the top marginal income tax rate.
Critics of the provision contend it taxes highly compensated private equity managers at a lower rate than comparably paid providers of labor or business services. Defenders of carried interest argue taxing it as income would be unfair because it represents capital gains even if they're not derived from recipients' capital.
Preferred Return, Clawback
Like most other alternative investments, private equity has complex compensation structures, often specifying the hurdle rate as well as the clawback. The hurdle rate, also known as the preferred return, is the minimum annual rate of return limited partners must earn to entitle the general partner to carried interest from fund profits. A typical hurdle rate is 8%.
The clawback provision lets limited partners recoup a portion of the carried interest collected by the general partner from past deals if subsequent losses lower their aggregate fund returns below the fund's hurdle rate.
Committed Capital, Drawdowns, Vintages
The money committed by limited partners to a private equity fund, also known as committed capital, is usually not transferred immediately. It is provided and invested over time as investments are identified.
Drawdowns, or capital calls, are issued to limited partners when the general partner has identified a new investment and a portion of the limited partner's committed capital is required to pay for that investment.
The year in which a private equity fund first draws down or calls committed capital is known as the fund's vintage year. Paid-in capital is the cumulative amount of capital that has been drawn down. The amount of paid-in capital that has actually been invested in the fund's portfolio companies is simply referred to as invested capital.
Cumulative Distribution
When private equity investors consider a fund's investment track record, they need to know the amount and timing of the fund's cumulative distributions,the total returns paid out to limited partners.
Residual Value
Residual value is the market value of the remaining equity that the limited partners have in the fund.It is common to see aprivate equity fund's net asset value, or NAV, referred to as its residual value, since it represents the value of all investments remaining in the fund portfolio. Private equity investors compare a fund's residual value with those assets' purchase price; any difference represents an unrealized profit or loss.
One common definition of residual value for private equity investment is the value of non-exited investments. Many private equity funds report this figure on a quarterly basis.
Private Equity Ratios
Now that we have defined the important terms, let's move on to some of the financial ratios commonly used in private equity investing. Private equity funds committed to Global Investment Performance Standards (GIPS) include these ratios when presenting their performance to prospective investors, and they are widely used by the private equity industry.
Investment Multiple
The investment multiple is also known as the total value to paid-in (TVPI) multiple. It is calculated by dividing the fund's cumulative distributions and residual value by the paid-in capital. It provides insight into the fund's performance by showing the fund's aggregate returns as a multiple of its cost basis. Because the investment multiple does not consider when the returns are distributed, it does not reflect the time value of money.
InvestmentMultiple=Paid-inCapitalCD+RVwhere:CD=CumulativedistributionsRV=Residualvalue
Realization Multiple
The realization multiple is also known as the distributions to paid-in (DPI) multiple. It is calculated by dividing a private equity fund's cumulative distributions by its paid-in capital. The realization multiple, in conjunction with the investment multiple, gives a prospective private equity investor insight into how much of the fund's return has actually been "realized"or paid outto investors.
RealizationMultiple=Paid-InCapitalCumulativeDistributions
RVPI Multiple
RVPI is the current market value of unrealized investments as a percentage of called capital. The RVPI multiple is calculated bytaking the net asset value, or residual value, of the fund's holdings and dividingit by thecash flowspaid into the fund. Cash flows are representative of the capital invested, fees paid, and other expenses incurred by the fund's limited partners.
Limited partners want to see a higher RVPI ratio, which compares the fund's remaining value to its limited partners' up-front capital costs. In conjunction with the investment multiple, RVPI reveals what proportion of the fund's total prospective return remains unrealized and dependent on the market value of its investments.
RVPIMultiple=Paid-inCapitalResidualValue
PIC Multiple
The PIC multiple is calculated by dividing paid-in capital by committed capital. This ratio shows a potential investor the percentage of a fund's committed capital that has been drawn down.
PICMultiple=CommittedCapitalPaid-inCapital
In addition to the above ratios, the fund's internal rate of return (IRR) since inception, or SI-IRR,is a common formula potential private equity investors should recognize. The SI-IRR is simply the fund's internal rate of return since its first investment.
New Global Investment Performance Standards (GIPS)
Since 2020, GIPS guidance for private equity firms has mandated the filing of a standardized disclosure. It includes all the multiples covered above as well as the annualized and composite since-inception money-weighted returns of the portfolio.
The Bottom Line
The private equity industry's historically strong returns have grabbed the attention of savvy investors. As the industry's influence grows, it will become increasingly important for investors to be familiar with industry jargon. Understanding the formulas used to evaluate private equity funds will help investors make smarter financial decisions.
