What could be simpler than calculating a fund’s investment multiple?
Investors know how much cash a fund has drawn down: cash in. They know how much has been distributed: cash out. They know the value of the investments that have yet to be realized: net asset value. Add cash out to NAV. Divide by cash in. And voila, you have your investment multiple, sometimes referred to as total value to paid in, or TVPI.
But alas, nothing about measuring private equity returns can ever be straightforward. Many buyout firms recycle distributions into fresh investments. According to the Buyouts Insider PE/VC Partnership Agreements Study 2016-2017, two-thirds of North American buyout firms have the right to reinvest or recycle proceeds from prior investments.
When distributions get earmarked for a new deal, the recycling sponsor neither draws down cash from investors nor distributes cash. And that can result in a significantly higher investment multiple than if the sponsor hadn’t engaged in recycling.
In a December white paper published by secondary-fund manager Landmark Partners, author Barry Griffiths, partner and director of quantitative research, provides an example to illustrate. Consider a firm that draws down $100 at time zero, then sells the investment and distributes $144 to backers at year two. It then draws down $144 at year two for a second investment, which it sells for $207 and distributes at year four. The investment multiple? That would be the $144 plus $207 distributed (cash out) divided by the $100 plus $144 drawn down (cash in), or 1.44.
Next consider a firm that draws down $100 at time zero. At year two, the firm sells its first investment and recycles the $144 into a new investment. The firm sells that second investment at year four and returns $207. In this case the investment multiple is 2.07 — the $207 distributed divided by the $100 drawn down. That’s quite a difference in investment multiple for what amounts to the same economic result for investors!
So what’s the answer to this problem? Data provider Bison recommends that in calculating investment multiples, investors should treat recycled distributions as distributions (cash out) and the amount that gets reinvested as contributions (cash in). This makes for an apples-to-apples comparison among different funds.
But keeping track of all the recycled investments can get messy. In his paper Griffiths offers a potentially simpler solution, introducing a new metric for a given set of fund cash flows called MaxMult. The calculation of MaxMult depends only on net cash flows — the difference between cumulative distributions and cumulative drawdowns — and is thus impervious to the effects of recycling.
“MaxMult is the highest value that TVPI can ever attain due to changes in recycling policy, given the same net cash flows seen by the investor,” wrote Griffiths. “As a result, MaxMult can be accurately compared across different funds with different recycling policies.”
Key to calculating MaxMult is identifying the point in time (called Tmax) at which investors are most out of pocket — when the difference between cumulative drawdowns and cumulative distributions is at its highest. This difference Griffiths calls NetPaid. You then find the difference between cumulative distributions and cumulative drawdowns after Tmax; this difference Griffiths calls NetValue.
NetValue divided by NetPaid gives you the MaxMult. In cases where a fund has not been fully liquidated, you first add NAV to NetValue before dividing by NetPaid.
You may find the concept of NetPaid a familiar one. Griffiths writes that “the notion that NetPaid, the maximum amount that ever comes from the investor’s pocket, is an important value has been discussed for some time.” He warns, however, that not all metrics involving NetPaid are useful. He calls out one in particular — total value divided by NetPaid — as “totally wrongheaded.” For one thing, the calculation doesn’t take into account drawdowns after Tmax.
So will the industry rush to adopt MaxMult? Data providers, advisers and academics are likely to give it a look. “It may very well be a useful metric, but I wouldn’t want to render a definitive judgment without analyzing its implications using our cash-flow data set,” wrote Mike Roth, vice president of research at Bison, in an email.
More than 20 years ago Austin Long and Craig Nickels, then working at University of Texas Investment Management Co, introduced the first public market equivalent calculation. The PME shows how much better or worse investors would have done investing in a public market index than in a particular private equity fund. The Kaplan-Schoar PME introduced in 2005 is particularly useful in that it doesn’t rely on the internal-rate-of-return calculation, widely viewed as flawed; in 2009 Griffiths co-authored a paper introducing direct alpha, which turns the Kaplan-Schoar PME into an annualized return analogous to an IRR.
The PME is catching on, particularly among academics and among the larger advisory shops. Griffiths said he’s seeing them show up in sponsor pitchbooks. But you still don’t hear them discussed very much by buyout professionals or their institutional backers at, say, industry conferences.
In this white paper Griffiths illustrates a flaw in the investment multiple and introduces a new metric to get around the problem for funds with the same net cash flows. Here’s hoping that if the industry finds it has merit, the MaxMult enjoys a faster uptake than the PME did.
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Correction: The last name of Barry Griffiths was misspelled in one of the later references of the original version of this article.