Hoh a lot of money do your private equity investments? The question is easy to answer for other asset classes, such as bonds or listed shares. All it takes is the price paid at the time of purchase, the price now, and the time that has passed between the two. It is less obvious how to calculate returns on private equity investments. Capital is earmarked for such investments, but this is only ‘called up’ once the investment firm has found a project. There is little information about the value after investment. Cash is returned in fixed amounts at irregular intervals.
An alphabet soup of measures is offered to investors, known as ‘limited partners’. There is irr (the internal rate of return, calculated based on the revenues for a specific project), MOM (the estimated value of a fund, deposited as a “multiple of money”) and a dozen others. They all have flaws. Some rely on private asset valuations, which could be flattering; others do not consider the cost of capital. But nitpicking seems pedantic as long as one metric remains high: cash distributions measured as a share of paid-up capital, known as ‘dpi”. This concerns the money that private equity companies transfer annually to the pension funds and university funds that invest in them, as part of the money that these investors have deposited. irr or MOM it is difficult to play and takes into account the high fees charged for accessing funds.
For the past quarter century, private equity firms have made distributions worth about 25% of the fund’s value each year. But benefits fell to just 14.6% in 2022, according to investment bank Raymond James. In 2023, they fell even further to just 11.2%, the lowest level since 2009. Investors are growing impatient. It is now possible to buy sweaters and T-shirts decorated with the slogan “dpi is the new irr‘ on Amazon, an online retailer. According to Bloomberga news service, an investor recently appeared in a copy at a private equity firm’s annual meeting.
It is understandable that dpi has fallen. As interest rates rose, stock valuations fell. Private equity managers can choose when to sell their portfolio companies. Why would they sell in a down market? Possible avenues for them to exit investments, such as taking a company public or selling it to another, are virtually closed. In the years following the dot-com bubble, which burst in 2000, and the global financial crisis of 2007-2009, benefits from private investments fell similarly.
Still, this slump could be more damaging than the last for a number of reasons. First, allocations to private equity have increased. Pension funds rely on income streams – dividends from companies they own, coupon payments from bonds and now distributions from private equity – to make payments to retirees. A decade or two ago, a lean year in private equity might not have mattered much. Now things are different.
Second, previous lean periods coincided with the fact that there were few other investment options for pension funds and university endowments, and plenty of opportunities for private equity managers. Some of the best returns private equity has achieved have come after crises or bubble bursts, when managers could acquire companies for next to nothing. But the past two years have offered few such opportunities. Now that interest rates are high, arranging financing is difficult; Although valuations fell, they did not fall. The result is that companies have a record $2.6 trillion in “dry powder”: capital committed by investors but not yet invested. At the same time, pension funds are eager to buy more bonds because of the high returns now offered.
How could this situation resolve itself? Stock markets are reaching record highs, and valuations in private markets tend to track those in public markets. The pipeline of IPOs is filling up nicely. Exits become possible. If all this continues like this, benefits could start to flow. Yet this is only one future scenario. Much of the market’s recent strength reflects the success of the biggest tech companies, which have been pumped up by excitement about what artificial intelligence will do to profits. And private equity funds typically own healthcare and home maintenance companies, rather than software companies. Moreover, US inflation appears worryingly stubborn, encouraging higher interest rates. Private equity investors will only be able to relax once they have their money in their pockets again. ■
Read more from Buttonwood, our financial markets columnist:
How Investors Misjudge Risk (March 7)
Uranium prices are soaring. Investors should be careful (February 28)
Should you put all your savings into stocks? (February 19)
Also: how the Buttonwood column got its name