For the past year, private equity managers have sought to prioritize returning cash to investors after higher interest rates stifled deal activity and exits. The drop in distributions has left many financial institutions that invest in private equity with less money to allocate to future funds. As a consequence, DPI, or distributions to paid-in capital, has replaced IRR, or the internal rate of return as the most important measure of private equity performance—at least for the time being.
IRR has long been favored by the private equity industry to demonstrate its superiority over public markets. And justify the hefty management and performance fees (?). IRR is a cash-weighted measure of return that takes into account the time value of money, which ROI, or return on investment, does not; which is helpful when committed capital is called over different points of time. However, there are also some unrealistic assumptions underpinning the mechanics of IRR calculations that can make returns appear more attractive than they really are. That effect is compounded by how private equity funds mark their assets.
The value of an asset is whatever someone is willing to pay for it. But in the absence of an active market for said asset, its value is whatever the fund manager says it is. Now, to be fair, fund managers do consult third-party valuation experts and their valuation processes are usually audited by well-credentialed firms at least annually. Still, as owners and experts on said asset, the fund managers' views carry a lot of weight. And it's not really in their economic interest to aggressively mark things down. So, even when public markets gyrate wildly, private equity valuations tend to remain relatively stable, as fund managers hold out hope for better times. In fact, this is actually an attractive feature of private markets for many investors, to chagrin of others.
But what if you have to sell? Recently, amidst funding cuts by the Trump administration, the liquidity needs of major university endowments have increased. For example, Yale is reportedly exploring the sale of up to a third of its private equity portfolio. And Harvard tapped the bond market raise $750 million to meet short-term needs. Heck, if multi-billion dollar endowments (like Harvard and Yale with $50.7B and $40.7B of assets, respectively) start selling their massive private equity portfolios to generate liquidity, fund managers are not going to be able avoid price discovery for very long. And investors, long shielded by IRRs, may find actual realized returns, or DPI, are a lot skinnier than they imagined.
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