Practical analysis for investment professionals
16 July 2018

Private Equity Funds: Leverage and Performance Evaluation

Antonella Puca, CFA, CIPM, CPA, is the author of Early Stage Valuation: A Fair Value Perspective from John Wiley & Sons.

Leverage is pervasive in today’s private equity markets. Portfolio companies generate it directly through guarantees and debt serviced, while private equity funds generate it through subscription lines of credit guaranteed by the investors’ capital commitments.

To obtain debt financing, a portfolio company must demonstrate that it has a well-developed business and can service its debt obligations — qualities that make it a potential target for leveraged buyout funds.

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With portfolio companies in their earlier stages, the source of any cash distribution is an important consideration for investors: Is the distribution a true “dividend” or a return of capital? How is the company generating cash for the distribution? Did it take on additional debt from related parties during the period of the distribution? Could the company have made the distribution without adding leverage?

Leverage at the portfolio company level can result from guarantees embedded in complex layers within the company’s structure that separate the fund from the operating entity. As part of the due diligence process, investors should inquire about these guarantees as well as other potential transactions among the fund, management (including any affiliates), and the operating companies that may reveal additional risks. Recently, funds have applied more leverage by entering into subscription lines of credit for periods that may extend well beyond those of a typical bridge loan.

Distinguishing between returns achieved through leverage and the manager’s ability to add value by, say, selecting superior investments and improving operations is critical to evaluating private equity fund performance. Reported performance figures are essential to comparing managers with similar strategies but different risk and return profiles based on how they apply leverage.

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Total Value to Paid in (TVPI)

Of course, calculating private equity fund performance is complicated by the irregular nature of a fund’s cash flows and the illiquidity of its investments. An important performance metric is total value to paid in (TVPI), or the ratio of the amount distributed to the investors plus the net asset value of the fund at the measurement date to the amount of invested capital. TVPI can be calculated for a single investment or for the total fund. A TVPI greater than 1 means the fund’s value and distributions exceed invested capital and that the fund is thus in a gain position. A TVPI below 1 indicates the fund has lost capital for its investors overall.

A critical question is how much actual value the fund has generated for its investors. This includes the unrealized component, or the fair value of the investments in the fund’s portfolio as of the measurement date. A shortcoming of TVPI is that it does not account for the timing of cash flows. For instance, a TVPI of 1.3 indicates that, based on the current investment valuation, the fund has generated 30 cents for every dollar invested, including the total of the cash contributions from the investors since the inception of the fund. However, this ratio does not indicate when the cash contributions took place, how long the fund took to generate the 30-cent return, or what the fund’s rate of return is on an annualized basis.

In private equity, fund managers usually have effective control of not only the selection of investments but also, through the mechanism of capital calls, the timing of investor cash: Managing cash flows is a key component of performance in these funds that is not captured by TVPI. To address this limitation, private equity funds also report the fund’s internal rate of return (IRR), a money-weighted return metric calculated from the inception of the fund through the measurement date, which is usually measured on an annualized basis.

The graphic below models IRR during the life cycle of a global benchmark of buyout and growth equity funds that began in 2002.

Benchmark Internal Rate of Return (IRR): Global Buyout and Growth Equity

Benchmark Internal Rate of Return (IRR): Global Buyout and Growth Equity

Source: Cambridge Associates

In a so-called J-curve effect, the IRR declines at first but turns positive towards the end of the second year. “Typically, the IRR of private equity funds stabilizes in its return quartile six to eight years into the life of the fund, when the fund’s risk/return profile also becomes stable,” says Richard Carson, senior director of private equity at Cambridge Associates. “In the first six to eight years, a fund may go through a variety of return quartiles. It is only towards the seventh year that the IRR stabilizes towards its final limit. Concerning target returns, the vast majority of private equity fund managers target a net annualized IRR of 15% or more. The target IRR for many managers is significantly higher than the net median IRR of the benchmark that we use at Cambridge Associate, but, based on my experience, it reflects the target of funds that strive to enter in the top quartile relative of the private equity peer group.”

One reason for the growth of a secondary market for private equity funds is because it makes funds investable in their later stages, when the IRR may be in positive territory. This helps avoid the J-curve effect and could deliver investors a more favorable return profile.

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Subscription Lines of Credit

Subscription lines of credit can influence a fund’s IRR profile as well. In this type of leverage, one or more lenders provide a fund with revolving credit facility. It is collateralized by a pledge of the right to call and receive capital contributions from the fund’s investors. Subscription lines of credit have traditionally been used in private equity funds as a form of short-term bridge financing to facilitate payments of expenses or investments and make the capital call process more efficient. In recent years, subscription lines of credit have evolved beyond this function and now can help manage the fund’s cash, with repayment terms often extending well in excess of 90 days.

As Anne Anquillare, CFA, president and CEO of PEF Services, notes:

“It is important to distinguish a subscription line of credit that is used to finance investments over a longer period of time versus the typical ‘bridge loan,’ which have strict limits in the use of advances (partnership expenses and for short-term deal financing). Typical terms that distinguish short-term loans is that the principal is generally payable within 120 days, it cannot be repaid with new advances and loans cannot be used for distributions. These lines have an operational nature and do not generally affect the risk profile of the fund in a significant way. They are very different from a longer-term subscription line of credit, which may indeed have a significant impact on a fund’s IRR and risk characteristics.”

In some cases, subscription lines of credit manipulate the mechanics of the IRR calculation, improving the fund’s stated IRR. This helps achieve the preferred return threshold required for the carried interest to kick in as additional GP compensation.

So how can a subscription line of credit affect a fund’s IRR?1

The Effect of a Subscription Line of Credit on IRR and TVPI


Source: Based on “Subscription Lines of Credit and Alignment of Interest,” Institutional Limited Partners Association (ILPA)

The first column in the chart above shows IRR when the fund has no line of credit. The manager calls $100 in cash from investors the first year, pays annual management fees of 2% over six years, and realizes a gross value of $162 at the end of the sixth year. This results in an annualized IRR of 6.62% over the period. TVPI in this case is 1.45, calculated as the realized value of $162 divided by $112, or the sum of the limited partnership disbursements. The second column demonstrates how a one-year line of credit at an interest rate of 4% per annum affects IRR. The leverage improves IRR since now the limited partners (LPs) have to disburse only $100 in cash, but TVPI is actually lower because of the interest expense. Similarly, in the third column, the IRR increases again, while the TVPI falls.

So subscription lines of credit can improve a fund’s cash flow profile by avoiding the J-curve effect. Longer-term subscription lines of credit also enable comparisons between managers that use them and those that do not.

In addition to the actual return, inclusive of the effect of the line as incurred by the fund (“with” the line of credit), many investors, particularly on the institutional side, now often ask for adjusted returns (“without” the line of credit) that treat the cash as if it came through a capital call rather than credit facility. In some cases, investors have gone further and requested fund managers provide a full download of the cash flows with which they calculate IRR. From this data, investors can then recalculate the IRR based on their own assumptions.

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So what’s the takeaway from all of this?

“To evaluate the performance of private equity funds,” Carson says, “it is critical for an investor to consider multiple metrics, including IRR, [public market equivalent] PME benchmarks, and multiples of invested capital like the TVPI. These metrics provide different perspectives on the manager’s ability to generate performance, and it is important to be able to consider all of them to truly understand the strategy and the results of the fund.”

For more from Antonella Puca, CFA, CIPM, CPA, don’t miss Early Stage Valuation: A Fair Value Perspective.

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1. With thanks to Gianluca Moretti for his insight and comments on the treatment of management fees and interest expense in this example.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/ Andrea Donetti / EyeEm

About the Author(s)
Antonella Puca, CFA, CIPM, CPA

Antonella Puca, CFA, CIPM, CPA/ABV, CEIV, is a Senior Director in the Valuation Services group of Alvarez & Marsal in New York and the author of Early Stage Valuation (Wiley, 2020). Prior to A&M she was part of the alternative investment group at KPMG/Rothstein Kass, where she helped launch RK’s Bay Area practice, the global hedge fund practice of EY in San Francisco and New York, the financial services team at RSM US LLP, and BlueVal Group in New York. Puca served as a director in the ethics and professional standards group at CFA Institute and as a volunteer focused on certifications and curriculum programs. She has served as an executive committee member of the board of the CFA Society of New York and as a member of AIMA's research committee. She is a member of the Business Valuation Committee of the AICPA. Puca is licensed as a CPA in California and New York. She is accredited in business valuation (AICPA), holds the valuation analyst and the entity and intangibles valuation certifications. Puca is a member of the Italian Professional Association of Journalists. She holds a degree in economics with honors from the University “Federico II” of Naples, Italy, and a master of law studies in taxation from NYU Law School. She has been an adjunct faculty member at New York University, a research fellow at the Hebrew University of Jerusalem, and a member of the 420 Italian National Sailing Team.

12 thoughts on “Private Equity Funds: Leverage and Performance Evaluation”

  1. Richard Turgeon says:

    IRR may be too easily manipulated. Prefer to focus on multiple on invested cash for apples to apple comparison. Thank you for a very good article.

  2. Very good. Thank you for the insight! Private equity firms using lines of credit to juice IRR at the expense of lower tvpi for limited partners is a developing trend that deserves more attention.

  3. Vuyani Joja says:

    Very informative article, good job…Thank you.

  4. Excellent article. Note that GPs seem to be working so hard to manipulate “performance” measures including IRR–spending time and money that unfortunately detracts from the returns that will ultimately make it to the LPs–that the LPs actually have to spend their own time and money to recalculate all the fake numbers coming from the GPs. It used to be that LPs had a choice between internal management and external management; now it appears that their choice is between internal management and external management PLUS internal management!

  5. Kirk Cornwell says:

    “Buy debt!” is one oversimplified theory of investing that works until it doesn’t. The parabolic increase of fiat money in the world does point apparent success toward those who find ways to use as much as they can regardless of how they get their “leverage”. The concept of money as a “shared illusion” is being tested. It begins with “safe banks” having “excess reserves” provided by “central banks” and ends with limited partners risking their hard-earned capital.

  6. Edin says:

    Thanks for the article. So, we are delaying the LP cash outflows by using debt. As a result, the IRR will, of course, be “better” due to the math we use to calculate it, but IRR tells nothing about the increased risk (as a result of using debt) … it does not automatically mean that there is additional value created for the investors; we would, of course, know that only after we properly calculate the (increased) discount rate (i.e. risk) for the LP cash flows … investors might be a bit mislead by this “better IRR through debt” …

    1. Brad Case, PhD, CFA, CAIA says:

      I could hardly have said it better, Edin.

  7. Thank you for the interesting article. One point that should also be considered is the return that can be earned on capital during the “deferral period” when leverage is employed. The TVPI in the ILPA example is identical in all three cases if the LPs earn a return on their $100 investment equal to the 4% interest during the period(s) prior to the date of investment. In other words, using leverage allows the LPs to put their capital to use elsewhere temporarily and if they earn a return equal to or higher than the interest rate, the resultant TVPI will be equivalent or better.

    1. Brad Case, PhD, CFA, CAIA says:

      I may be missing something, Gary, so let me summarize my understanding of the situation you’re describing. I’ve identified an investment that I think will return at least 4%, but for some reason I’m not going to use equity capital to make the investment. Instead I add debt capital. If the investment doesn’t pay off, then I have to use my investors’ equity capital to pay off the debt, plus the interest on the debt, so my investors are worse off. If the return on the investment exactly equals the cost of the debt–which will be higher as I use more leverage–then I’ve done nothing for returns but I’ve increased risk. If the return on the investment exceeds the cost of the debt then I’ve increased the return on equity, but (1) I’ve used debt when I could have used equity instead, (2) increased my performance fee, (3) reduced my investors’ return on an unlevered basis, and (4) reduced my investors’ return on a risk-adjusted basis. TVPI will be higher even though my investors are worse off. Why is increasing TVPI in that situation a good thing?

      1. Arnold says:

        Brad, note that Gary concludes that TVPI will show a higher value when the return on the non-called money is added to total return. He doesn’t say that it is a good thing.
        Gary is correct that this return should be added, but the difficulty with capital calls is that an LP is usually only asked on short notice to provide the capital. Therefore the LP will probably place part of his commitment on a short, low yielding, investment. A side effect of this increasing use of credit lines might be that LP’s will increase their commitment above the amount they actually want to invest as part of it will be financed by credit anyway.

        1. Brad Case, PhD, CFA, CAIA says:

          Thanks, Arnold. Now that I’ve re-read Gary’s comment, I realize that he was talking about the LP using the equity capital during the period when the GP is using borrowed capital rather than calling the equity capital, whereas I was thinking about the GP using called equity capital plus borrowed capital.
          I agree with your expectation that the committed equity capital is likely to earn only cash returns.

  8. Good article. These issues should be routinely brought to the attention of LPs.

    The ultimate resolution would seem to be reliable and standardized , GP-independent,valuation techniques that would allow to compare periodic returns similar to performance in the public equity market. AICPA has made a valuable contribution in this direction with the recently published set of guidelines. The extent to which they are implemented in practice remain to be seen.

    One of the challenges is having vendors to provide valuation service on the behest of LPs rather than GPs. Otherwise, we get into the all two familiar world which is direct analogue to credit rating agencies rating the parties that pay for the ratings.

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