Learn the Lingo of Private Equity Investing

Private equity was once a realm that only sophisticated investors could access. Now, mainstream investors are venturing into the world of private equity.

Private equity is capital or ownership shares not publicly traded or listed on an exchange. Private equity is often an investment in or buyout of a large public company that is then taken private. Investors raise capital to invest in private companies for mergers and acquisitions, to inject funds to stabilize the balance sheet, or to pursue new projects or developments. The amount of capital invested is often substantial and provided by accredited or institutional investors. Because of the non-public nature of private equity, it can be difficult to understand the lingo used by insiders. Read on to learn more about the different private equity terms and the ratios that have been raising the eyebrows of even the most sophisticated institutional investors.

Before we can discuss the important ratios used in private equity, we must first explain some of the basic terms. Some of these terms are strictly used in private equity while others may be familiar depending on your exposure to alternative asset classes, such as hedge funds.

Limited partners are usually institutional or high-net-worth investors interested in receiving the income and capital gains associated with investing in a private equity fund. Limited partners do not take part in the fund's active management. They are protected from losses beyond their original investment as well as any legal actions taken against the fund.

General partners are responsible for managing the investments within the private equity fund. They can be legally liable for the actions of the fund. For their services, they earn a management fee, typically 2% of commitments paid annually although there are exceptions when the rate is less. In addition, the general partners earn a percentage of the fund's profits, which is called carried interest. Carried interest is the general partner's share of the profits of the investments made within a private equity fund. The share can range from 5% to 30% of the profits.

Like most other alternative investments, private equity compensation structures can be complicated and usually include clauses. Two of the main types of clauses are the preferred return provision and the clawback provision. The preferred return, or hurdle rate, is basically a minimum annual return that the limited partners are entitled to before the general partners may begin receiving carried interest.

If there is a hurdle, the rate is typically around 8%. The clawback provision gives the limited partners the right to reclaim a portion of the general partner's carried interest in case losses from later investments cause the general partner to withhold too much carried interest.

In the private equity world, money that is committed by limited partners to a private equity fund, also called committed capital, is usually not invested immediately. It is drawn down and invested over time as investments are identified.

Drawdowns, or capital calls, are issued to limited partners when the general partner has identified a new investment and a portion of the limited partner's committed capital is required to pay for that investment.

The first year that the private equity fund draws down or calls committed capital is known as the fund's vintage year. Paid-in capital is the cumulative amount of capital that has been drawn down. The amount of paid-in capital that has actually been invested in the fund's portfolio companies is simply referred to as invested capital.

When private equity investors consider a fund's investment track record, they need to know the amount and timing of the fund's cumulative distributions, which is the total amount of cash and stock that has been paid out to the limited partners. 

Residual value is the market value of the remaining equity that the limited partners have in the fund. It is common to see a private equity investment's net asset value, or NAV, referred to as its residual value, since it represents the value of all investments remaining in the fund portfolio. Private equity investors compare their fair value with the residual value of the investment's purchase price; any difference represents the potential or unrealized profit or loss from the sale of the shares.

One common definition of residual value for private equity investment is the value of non-exited investments reported by funds. Private equity-sponsored funds tend to report this figure on a quarterly basis. Residual value is more important for limited partners than it is for general partners because it demonstrates the current market or fair value of the remaining equity owned by limited partners only.

Now that we have outlined some of the important terms, we will explain some of the ratios used in private equity investing. The Global Investment Performance Standards (GIPS) require that the following ratios be present when private equity firms present their performance to prospective investors.

The investment multiple is also known as the total value to paid-in (TVPI) multiple. It is calculated by dividing the fund's cumulative distributions and residual value by the paid-in capital. It provides insight into the fund's performance by showing the fund's total value as a multiple of its cost basis. It does not take into account the time value of money.

$Investment\ Multiple = \frac{Cumulative\ Distributions + Residual\ Value}{Paid\text{-}in\ Capital}$Investment Multiple=Paid-in CapitalCumulative Distributions+Residual Value​

The realization multiple is also known as the distributions to paid-in (DPI) multiple. It is calculated by dividing the cumulative distributions by paid-in capital. The realization multiple, in conjunction with the investment multiple, gives a potential private equity investor insight into how much of the fund's return has actually been "realized" or paid out to investors.

$Realization\ Multiple = \frac{Cumulative\ Distributions}{Paid\text{-}In\ Capital}$Realization Multiple=Paid-In CapitalCumulative Distributions​

The technical definition of RVPI is the current market value of unrealized investments as a percentage of called capital. The RVPI multiple is calculated by taking the net asset value, or residual value, of the fund's holdings and dividing it by the cash flows paid into the fund. Cash flows are representative of the capital invested, fees paid, and other expenses incurred by the limited partners to the fund.

Limited partners want to see higher RVPI ratios, which demonstrate the total multiplied values of their up-front capital costs. It provides a measurement, in conjunction with the investment multiple, of how much of the fund's return is unrealized and dependent on the market value of its investments.

$RVPI\ Multiple = \frac{Residual\ Value}{Paid\text{-}in\ Capital}$RVPI Multiple=Paid-in CapitalResidual Value​

The PIC multiple is calculated by dividing paid-in capital by committed capital. This ratio shows a potential investor the percentage of a fund's committed capital that has actually been drawn down.

$PIC\ Multiple = \frac{Paid\text{-}in\ Capital}{Committed\ Capital}$PIC Multiple=Committed CapitalPaid-in Capital​

In addition to the above ratios, the fund's internal rate of return (IRR) since inception, or SI-IRR, is a common formula that potential private equity investors should recognize. It is simply the fund's internal rate of return since its first investment.

The private equity industry has grabbed the attention of savvy investors. As the industry's influence on our financial market grows, it will become increasingly important for investors to be familiar with the lingo used in the private equity industry. Familiarity with and understanding of the terms and ratios used in private equity will help investors make smarter financial decisions.