ROI MATTERS MORE THAN EVER
CALLS FOR SCRUTINY REQUIRE COMPREHENSIVE ROI MEASUREMENT IN PE AND VC FUNDING
In light of the recent intensified economic diversification and development efforts in the GCC, private equity (PE) is emerging as a relatively new asset class in the region. Interest in ‘growth capital’ rather than the more traditional ‘buy out’ PE can be seen in the developed markets of the UAE and Western Europe, with venture capital (VC) seeing a a surge following the success of VC unicorns such as Careem and the purchase of Souq.com by Amazon.
However, the highly-publicised case of the Abraaj Group’s collase has the industry calling for more robust corporate governance in the region. Local PE managers are facing far greater scrutiny as investors are beginning to pay more attention to how funds are being handled. Buyers and investors increasingly want to base their decisions to enter the PE market through proven and tested information, considering factors such as past performance, and also due diligence on investment and operations.
While measuring the absolute and relative performance of private markets is critical, it is significantly nuanced. ‘Value creation is an important aspect in the PE story, and its measurement should be accurate and meaningful. Evaluating past performance is always a factor when deciding whether or not to include PE within the overall asset allocation of a portfolio. However, investors must dive deeper to determine a fund’s true performance, through rigorous due diligence. A combination of metrics and qualitative measures are important for providing a holistic understanding of a fund’s track record and its future potential.
In terms of quantitative metrics, the three most commonly used ones are internal rate of return (IRR), total value to paid-in (TVPI) ratio and distributed to paid-in (DPI) ratio.
The internal rate of return (IRR) is the most widely cited metric for measuring the performance of private market investments. This is a timebased measurement which takes into account the investment made and acquired over a period of time. The longer an investment takes to mature (or sell at a given price), the lower an annualised IRR.
The second ratio, total value to paid-in (TVPI), considers how the sum value received from investments (through dividends and a sale at the end) compares to the initial investment made.
The final measure is the distributed to paid in (DPI) ratio. Again, in simple terms it measures how much of the initial capital is returned (though dividends or other payments) compared to how much was invested initially. DPI is a barometer of realised value, not total value.
All three metrics play an important role in helping investors evaluate a private equity fund’s historical performance. No single metric can accurately assess the performance of a fund, but when employed altogether, they can help paint a more comprehensive picture.
Gauging a fund’s past performance doesn’t reveal much about the performance of the next PE fund; long investment timescales make it necessary to consider other investment related factors as well, including how investment teams source deals, how they create value at their portfolio companies, and the stability of the team itself. Following the Abraaj case, assessing managers and back office operations have become an essential measure of due diligence. Effective internal controls, strong systems and a well-staffed operations team are critical for a private equity fund to succeed.
Measuring private market performance is complicated. It needs a clear view of relevant metrics, is informed through multiple perspectives, and demands specificity of analysis. Additionally, it can be subjective, prone to manipulation and represent an imperfect assessment of the success of a private market investment.
However, private market performance measurement will evolve and improve on its current shortcomings. The key for investors is to identify investment talent that can generate strong returns sustainably, and undertake deep ‘qualitative’ measurements with operational due diligence to assess the likelihood of future investment success.