It’s all on paper… until its in your pocket.

In our exercise today, we’re running through a hypothetical portfolio of private equity investments (purely illustrative… not a real fund). But the math is real.

Our goal here is to get a pulse on what’s really going on in the PE fund’s portfolio of companies.

Fund Construction / Assumptions:

We’ll keep it very simple: Invest $1B across 10 portcos, $100M each

• Fund Size: $1B ($1,000M)

• 10 portfolio companies

• $100M equity / portco

• We start laying this out below:

A Quick Note on Calculating Fees

• To keep things simple, let’s think about everything here on a “gross” basis (e.g. we are not “netting” out the impact of fees on returns)

• Remember, PE funds charge management fees and performance fees

• This is most often the “2 and 20” you hear referenced

  • 2% annual management fee charged every year

  • 20% carried interest / performance fee

A quick refresher on how carried interest fees are calculated in the context of a deal:

• Example: 3x Gross Deal with 20% Carried Interest Example:

  • 20% Carried Interest means the PE fund takes 20% of the profits on a specific deal

  • Let’s say a deal returns 3x the original investment on a “gross” basis

  • If we invested $100M, that means the deal at exit is worth $300M

  • $300 - 100 = $200M of profits

  • 20% Carried Interest means the PE GP gets to take home 20% of the $200 profits

    • 20% Profit: $200 × 20% = $40M of carry to the GP

  • The LPs who invested money in the PE fund will take home the following:

    • 80% Profit: $200 × 80% = $160 of profits to the LPs

    • Invested Capital: $100 × 100% = $100 of original LP capital

    • Total Return: Profit + Original Investment = $260 total investment profits

  • Returns Math:

    • Gross MOIC or TVPI = 3.0x:

      • “3x gross” return = $300 gross proceeds / $100 invested

    • Net MOIC or TVPI = 2.6x:

      • The return, net of fees to the PE GP, to LPs is actually a 2.6x “net” return

      • $260 net proceeds / $100 invested

Back to our fund portfolio example - what is going on in the fund snapshot? What is the PE firm saying is going on with the portfolio?

Let’s say we take everything at face value before we start dissecting things…

Here’s what the fund is telling us based on the fund performance snapshot below:

• [A] Invested Capital: $1,000M

  • this is the total invested capital from all of the LPs, including our investment

  • this represents all of the equity invested in the fund that is then used to buy companies

  • the $1,000M fund was fully deployed from Jan 2017 to July 2021

• [B] Total Realized: $1,425M

  • The fund has started seeing realizations on its portfolio companies

  • This is the money that is IN OUR POCKETS

    • If its not included in this realized value… then its all on paper

  • This is the sum of [B1] and [B2], Partial Realizations and Full Exits of PortCos

• [B1] Partial Realized: $825M

  • The fund has been able to take some money off the table for some of its deals

    • Perhaps the company had excess cash flow that was returned to investors as a “dividend”

    • The company may have even refinanced its debt from the original investment in what is called a “dividend recap”

    • Maybe a partial stake of the company was sold

  • Whatever the reason, these companies are partially exited and there is still unrealized value that remains (see [C])

• [B2] Final Exit (e.g. Fully Realized): $600M

  • These are full exits of a portfolio company and there is no unrealized value remaining

  • The PE fund has fully exited a deal and returned all of the money (and hopefully profits) to investors

  • PortCos #4 and #5 are fully exited

• [C] Unrealized Value: $1,670

  • Some of the companies have had no exits, e.g. the more recent deals #7, 9, 10 and no partial realizations

  • Unrealized value also captures some of the [B1] “partially realized” companies that still have unrealized value captured here

  • “Unrealized” value is critical our analysis so we are going to double-click this below

  • Why, you might ask?

    • Because its not a “real” number → its the fund’s estimate of “fair market value” and unless its money in our pocket, who’s to say if its “real”

  • This is all on paper

    • UNTIL ITS IN YOUR POCKET, ITS NOT REAL

• [D] Total Value: $3,095

  • Total Value = [B] + [C] or Realized Value + Unrealized Value

    • $3,095M = $1,425 + $1,670

  • The goal here is to capture the “current” value of a fund’s portfolio of companies accounting for any money that has been returned to investors through exits and any money that has not yet been returned

  • This is the number that gets most widely referenced by PE GPs and often LPs when they are analyzing the fund, because it flows into the fund’s MOIC / TVPI / MoM, which we will discuss further below

  • Its crucial to remember that once again, the total value includes unrealized value… in our case, over half (50%) of the “returns” here are purely “on paper”

  • The only money in our pocket is the “realized” value

Okay, okay, I get it → We did some math and some of the portfolio value is “real” and some is “on paper” → Cool, now what? Why do I care?

All of this math is used to calculate the fund’s performance KPIs: DPI, RVPI, TVPI

• The good news is there are some standard terms that LPs and GPs use to communicate about fund returns

• Note that in this analysis, we are only talking about returns “multiples”

  • We aren’t getting into “IRR” or Internal Rate of Returns here

  • But this is important to note because IRR is very important measurement as well since IRR takes time into account

  • IRR factors in the timing of investment cash flows

    • When money goes out the door and when it comes back in… not just the sizing of how much returns

  • For example:

    • IRR will differentiate between a deal that returns 3x over 5 years (25% IRR) vs. 3x over 20 years (6% IRR)

    • So two different 3x deals with vastly different investment timelines are not the same

  • More on this another time

Sharing our performance snapshot again for reference:

So → what are the performance multiples we care about for a fund?

There are three (3): DPI, RVPI and TVPI.

• DPI: “Distributed to Paid-In Capital”

  • DPI measures how much of the invested capital has been returned to investors as cash distributions.

  • Calculated as DPI = Total Realized Value / Invested Capital

    • $1,425 / 1,000 = 1.4x

  • On our fund snapshot:

    • [E] = [B] / [A]

• RVPI: “Residual Value to Paid-In Capital”

  • RVPI measures the unrealized value remaining in the fund relative to the invested capital.

  • Calculated as RVPI = Unrealized Value / Invested Capital

    • $1,670 / 1,000 = 1.7x

  • On our fund snapshot:

    • [F] = [C] / [A]

• TVPI: “Total Value to Paid-In Capital”

  • TVPI measures the total value generated by a private equity fund relative to the capital invested by LPs

  • Includes both realized and unrealized gains

  • Note sometimes TVPI is referred to as “MOIC” or Multiple on Invested Capital (or “Mark” referring to how the valuation is “marked” on the “books”)

  • Calculated as TVPI = (Realized + Unrealized) / Invested Capital

    • ($1,425 + 1,670) / 1,000 = 3.1x

  • On our fund snapshot:

    • [D] / [A] = ([B] + [C]) / [A]

So what’s actually going on in this fund?

Here’s a quick summary of how the fund is performing on paper:

• Fund Level Returns:

  • DPI = 1.4x

  • RVPI = 1.7x

  • TVPI = 3.1x

So the fund is a ~3x gross fund.

But again, over half of the fund’s value is only “on paper” because the TVPI includes 1.7x of RVPI or $1.7B of unrealized proceeds out of the $3.1B “fair market value” for the fund.

So I follow the math… what do I do with all of this? What questions do I want to answer to understand how a fund is actually doing?

What are the things we can do as an investor to understand if this is actually any good for a fund?

1. First, we would want to benchmark the fund against other funds within its vintage

   • For this, we would pull data from fund benchmarks like Preqin or Cambridge Associates and we could compare how a 1.4x DPI and 3.1x TVPI compares vs. other funds that launched in the 2017 Vintage

   • The vintage captures the year when the fund first started investing

   • We could further double-click into things like the fund’s sector - let’s say its healthcare - we would compare against other healthcare 2017 vintage funds

2. Second, but perhaps more important… we need to analyze the actual portfolio companies and see what’s going on

   • At the end of the day, the fund level returns are just an aggregation of the underlying portfolio companies realized returns + unrealized “fair market values”

   • Our job is to figure out how real those unrealized returns are and how likely they can be achieved… to better contextualize how real or not fund level returns might be

What can we do to analyze the fund portfolio company valuations?

Our job here is not dissimilar from any fundamental investment analysis / valuation work. We’re trying to determine if we agree with the value of the company on the fund’s books.

1. We can look at the quarterly valuation reports / analysis for the portfolio companies

   • How does the fund value the company?

   • Are they doing discounted cash flow analysis, assigning an EBITDA multiple to the company based on public comps or precedent transactions? Do we agree with their approach?

   • Do we think the “exit” multiple they assign the company is reasonable?

   • Is the operating model forecast for the company reasonable?

   • Do we agree with the revenue and EBITDA forecasts?

2. How is the portfolio company doing vs. the original Investment Committee (“IC”) forecast and plan for the company?

   • While the original IC forecast and plan for the company is not directly related to whatever the current fair market valuation is for the business… its still a very good indicator of:

     • how the PE fund thinks about the business

     • how accurate they are at forecasting the business

     • how well they understand what’s actually going on

     • how well they are delivering on their promises (e.g. forecasts)

   • And we can use what we learn to infer how legitimate or not the current “mark” for the company is

3. We can look at the fund’s history of reporting internal valuations vs. their track record of realized returns on exited deals

   • Does the fund tend to under promise and over deliver?

   • Or is there a history of inflating valuations and exiting below the fund’s internal “marks” for portcos?

4. We can meet with the actual investment team at the PE firm and hear firsthand how the deal is going

   • This is one of the best things you can do and one of the most important pieces of diligence

   • How well does the team have a pulse on what’s going on at the company?

   • Does the team give the impression that the deal is going better or worse than how its “marked” on paper?

5. We can talk to our own network of GPs and LPs and get a feel for the market and deal dynamics

   • Other institutional LPs, especially those who have invested with this PE GP before, can speak to the GP’s track record of marking investments and delivering on those unrealized returns

     • Do they think the GP is aggressive with their marks?

     • Conservative?

     • Fair?

   • You can also learn from bankers and other PE investors what multiples they’re seeing for similar assets are trading for and what’s a realistic exit multiple

     • You can figure out who realistic buyers are for the asset… if no one buys the asset… its all “on paper”

   • Our goal is to pressure test if the GP is being fair with their marks or if there are other forces at work

At Gather Capital, we curate a set of world class private equity opportunities enabling our clients to invest alongside elite family office limited partners.

If you’re interested in learning more about what we do, feel free to:

• swing by our website & create an account (if you haven’t already)

• grab some time on our calendar here

• shoot us an email

We’re looking forward to Talking Shop with you soon.

Sincerely,