Table of Contents
How is private equity performance measured?
Private equity returns
Private equity returns vs. public equity returns
The bottom line
Sep 12, 2022
6 min read
Learn how private equity performance is more difficult to calculate than public equity. Investors ought to learn the metrics by which PE performance is calculated.
According toMcKinsey & Co., PE funds since 2008 outperformed other private market asset classes and equivalent investments in public markets. However, this isn’t always the case, and because these privately held assets don’t make public financial disclosures, judging their performance poses certain challenges.
The standard PE benchmark metric, the internal rate of return (IRR), may reflect PE outperforming other assets in a one-year period. But that PE investment may not ultimately have a higher total return when the fund exits its investment, which can take a decade. This is why it’s important to compare PE metrics with that of other asset classes.
Private equity investors are long-term investors. High-net-worth individuals and institutional investors establish a fund, buy out a public company and take it private, or take control of an established private company and ready it for an initial public offering (IPO). The process can take a decade or more–the time it takes to find a company to buy and restructure with the goal of improving its operations. When a fund exits its investment, it generally divests by selling the company to a corporate buyer or by selling shares in an IPO.
PE investors don’t realize a return until the fund exits the investment. They trade access to that cash, or liquidity, for the prospect of a higher eventual return. For that reason, PE investing is for high-net-worth individuals and institutional investors who can afford to tie up substantial funds for a long period.
Private equity firms and experienced investors consider several valuation metrics to get a comprehensive picture of private equity performance. These metrics include:
The expected growth rate of an investment, expressed as a percentage. IRR is different from the more familiar annualized return on investment, which is a measure of the growth of an investment every year it is invested, factoring in compounding. In contrast, IRR factors in the timing of cash flows and assumes that distributions will be reinvested automatically, even if they aren’t. At the end of a year, IRR shows investors the rate at which their investment made gains or losses for that year. Because it measures growth but not a total return, the metric is better suited for long-term investments like private equity. For most PE investors, IRR is the key measure of performance.
The final amount an investment is worth, divided by the initial investment. This is also known as the multiple of money or the investment’s net total return. Unlike IRR, it doesn’t factor in the rate of return or the time horizon for the return. The main use of MOIC is understanding the total return.
). This metric is how a PE fund’s investment compares to the same investment made in public financial markets during the same period.
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To get a comprehensive understanding of PE returns, investors seek to understand an investment’s rate of return (IRR) and total return, as well as how the return compares with those for public equities and other investment classes in a certain period.
The IRR for a year doesn’t necessarily reflect the eventual return of the investment. For instance, in one scenario, an investment may take in cash at the beginning, showing a high IRR, and then make a lower return thereafter. In another scenario, an investment may take all its return at the end, but make twice the overall return of the first example. The latter example would have a lower IRR, but ultimately be the more profitable investment. Because of this, IRR should be used within the context of other metrics.
By contrast, the annual return for a stock shows how much that investment has increased or decreased over the course of a year. If an investor wanted to calculate the overall growth of a portfolio over the course of a year, they would take total growth and divide it by the initial investment to calculate ROI. For instance, imagine an investor with a portfolio of 16 stocks invests $12,000 at the beginning of January, and the portfolio is worth $16,000 on Dec. 31. The $4,000 of growth divided by the original $12,000 investment is an ROI of 33%.
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Technically, venture capital is a form of private equity. However, private equity funds fully buy out a company, makes a long-term investment, and collects its return upon its exit. Venture capital doesn’t buy entire companies and usually invests during a company’s startup phase. This is why many investors expect the return for private equity to be higher than that for venture capital. However, this is not a rule that holds true for all years.
According toCambridge Associates’ U.S. Private Equity Index, PE had an average annual return of 14.65% in the 20 years ended December 31,2021. In comparison, theCambridge Associates U.S. Venture Capital Index found that VC returns averaged 11.53% in the same 20-year period. YetVC outperformed PE in the 10 years between 2010 and 2020, with average annual returns of 15.15%.
Private equity is a long game. Investors commit their funds and can’t add more to it or take their funds out until the fund exits its investment, which can take a decade or longer.
In contrast, public equity involves companies that are traded publicly on a financial exchange. These companies offer equity in the form of shares to any investor who wants to purchase them. Shareholders can buy and sell shares whenever they want, making public equity highly liquid: Investors can invest more or pull their cash out at any time.
According to Cambridge Associates, for the 20-year period ended in June 2020, PE had average annual returns of 14.65% compared with the S&P 500, which had average annual returns of 5.91% over the same period. However, these high averages are not the case every year. The 10-year average annual return also ended June 2020 was 13.99% for the S&P 500, compared with 13.77% for private equity.
The pandemic suppressed private equity deal activity in 2020. But according to McKinsey & Co., private equity investing rebounded in 2021, partly due to pandemic-related government stimuli, setting new records in 2021 for dealmaking and exits. According toBain & Co.’s report on global private equity, PE fund general partners had their second-best fundraising year in the industry’s history in 2021. However, rapidly rising inflation caused in part by lingering global supply chain issues and labor shortages because of COVID-19 may challenge PE’s expansion. Investors, too, may be looking at PE returns with a more skeptical eye, understanding that high short-term IRR rates may not equate to long-term returns.
Private equity performance is more difficult to calculate than public equity performance, both because portfolio companies are private and not required to report to the public, and because investors don’t see a return until the fund exits its investment. As such, fund managers may report performance using multiple metrics.
When used together, these metrics can give investors a comprehensive understanding of PE returns annually and over time. These metrics may artificially inflate it at any point in time. Investors ought to learn the metrics by which PE performance is calculated and understand its performance compared with other asset classes over time.
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