BVCA

From www.bvca.org. BVCA copyright.

Measuring Performance: The Internal Rate of Return

Introduction

Returns may be measured in a number of ways. One may, for example, measure the payback period, that is to say the number of years required for the expenditure associated with a project to be recouped; or one might measure the book rate of return, this being the average annual profit made by an investment as a proportion of the original outlay. Each of these simple techniques exhibits serious deficiencies however. For example, payback does not consider the total profit which may be earned; neither method accounts for the time value of money nor for situations in which more than one investment is made.

The most common measure of performance within the private equity sector is the internal rate of return. Industry-wide private equity performance studies in the US use the IRR. Not only does this measure take the time value of money into account, as well as the ability to measure the returns on groups of investments, but it also expresses the return as a simple percentage. Thus, the BVCA has selected the IRR as being the most appropriate performance benchmark.

Private Equity/Venture Capital Managers and/or their Funders may additionally require performance to be calculated using other measures. Such arrangements between Private Equity/Venture Capital Managers and their Funders are, of course, entirely acceptable. Other benchmarks might include the following: a measure of the cumulative investment returned relative to the invested capital; the valuation of the unrealised portfolio relative to the cumulative drawn-down capital; and the payback period.

The IRR is that rate of discount which equates the present value of the cash outflows associated with an investment with the sum of the present value of the cash inflows accruing from it and the present value of the valuation of the unrealised portfolio.

Three Levels of IRR Advocated by the BVCA

Pure IRRs can only be computed when all investments have been realised and the cash has been paid back to Funders, after the deduction of carried interest, management fees and other applicable professional and ancillary charges. This is the net ('cash-on-cash') return on the wholly realised investment portfolio.

However, users of financial information regarding Private Equity/Venture Capital Companies need to be able to measure returns on a regular basis. Such interim returns are no more than indicators of the pure IRR. The more mature an investment portfolio is, though, the more confidence one may generally ascribe to these interim statistics.

Performance calculations must quantify the prowess of the Private Equity/Venture Capital Managers at two main stages: firstly, on their ability to choose suitable investment opportunities, manage them and divest from them; and secondly, to assess their overall cost effectiveness by computing the return to Funders net of the total cost of carrying out these tasks.

The first of these stages, that is the gross return, may be usefully broken down into two levels. This enables the actual return on realised investments only to be identified separately from the gross return on all investments, which by its very nature is estimated; the latter accounts for all wholly and partially realised investments and for the subjective element of valuations on the unrealised portion of the portfolio.

The BVCA, therefore advocates that performance be measured at three levels:

1. The Gross Return on Realised Investments

This return takes account of the cash outflows (investments) and inflows (divestments, including realisation values, dividend and interest payments, repayments of the principal of loans, etc) which take place between the Fund and its realised investments.

For the purposes of this return it is recognised that there are occasional circumstances in which it would be appropriate to include the realised element of gains from a holding in a Portfolio Company where full realisation has not been effected.

In deciding which partially realised gains should be included in this category the following rules should be observed:–

• Only those realised gains should be included which represent a substantial part (>30%) of the cost of equity investment. In that case, all cash inflows relating to that equity investment are to be included in this level.

• If the investment is made at different costs per share at different dates, the allocation of gain to cost should be based on the average cost per share of the realised investment.

• Partial write-offs should not be included in this level, but will appear in the Gross Return on all Investments.

• Full disclosure should be made of those investments where partial realisations are included in this level, in particular as to the allocation of gain to cost.

2. The Gross Return on all Investments

This return takes account of all of the following:

• The cash outflows (investments) and inflows (divestments, including realisation values, dividend and interest payments, repayments of principal of loans, etc) which take place between the Fund and:–

  • its wholly realised investments;

  • its partially realised investments; and

  • its wholly unrealised investment

• The valuation of the unrealised portfolio (consisting of wholly unrealised investments and the unrealised portions of partially realised investments but excluding cash and other assets held in the portfolio).

This return does not take account of carried interest or charges of any kind, such as management fees paid to the Private Equity/Venture Capital Company by the Funder, fees paid by a Portfolio Company either to the Fund or the Private Equity/Venture Capital Company, and fees paid or due to lawyers and accountants.

3. The Net Return to the Funder

This measures the return earned by the Funders in the Fund, and takes account of:–

• The cash flows which take place between the Fund and the Funders, net, by definition, of all of the following:

  • the Private Equity/Venture Capital Company's carried interest;

  • the management fees paid to the Private Equity/Venture Capital Company by the Funders;

  • all other applicable professional and ancillary charges which are paid out by the Private Equity/Venture Capital Company in the course of investing, managing and divesting from its investment portfolio

• The valuation of the unrealised portfolio (consisting of the unrealised portions of partially realised investments, wholly unrealised investments and also including cash and other assets), after deducting the implied carried interest.

When the portfolio is fully realised/fully distributed, the Net Return is the 'cash-on-cash' return to the Funders.

Should Private Equity/Venture Capital Managers and/or their Funders consider it desirable to do so, the performance calculated for any of the three levels given above may be broken down to demonstrate the contribution made by the individual elements of which they are made up. For example, the overall measure of the Gross Return on all Investments could be split up so as to separately show the performance of the wholly realised investments, partially realised investments, wholly unrealised investments, and the valuation of the unrealised portfolio.

The ability to break down the impact of the valuation of the unrealised portfolio on the performance may be particularly important as valuations can be no more than indicators of the pure IRR when all investments have been wholly realised.

To enable the returns calculated in accordance with the different Levels described herein by various users to be fairly compared, necessitates that the relevant parameters are always treated in an identical manner. It is for this reason that the Principles have been developed, which are set out below.

Principles

Commitments made by a Private Equity/Venture Capital Company to a Portfolio Company

The cash outflows should be taken to be the capital actually invested in a Portfolio Company at a given point in time. A Private Equity/Venture Capital Company may commit itself to making a series of investments in a Portfolio Company over an extended period of time. In such circumstances, the timing and amounts of the individual cash flows only should be taken into account.

Commitments made by a Funder to a Private Equity/Venture Capital Company

The cash outflows should be taken to be the capital actually invested in a Private Equity/Venture Capital Company by a Funder at a given point in time. A Funder may commit itself to making a series of investments (known as draw-downs) in a Fund over an extended period of time. In such circumstances, the timing and amounts of the individual cash flows only should be taken into account.

Equity Received in Lieu of Cash

Any equity received by a Private Equity/Venture Capital Company in lieu of cash in respect of services rendered to a Portfolio Company (for instance, services of directors, provision of guarantees) should be considered as investments of zero cost.

Net Return to the Funder: Carried Interest and the Unrealised Portfolio

When calculating the Net Return to the Funder, as regards the valuation of the unrealised portfolio, appropriate provision should be made for the deduction of carried interest after taking account of any hurdle rates.

Non-Domestic Currency

Where transactions take place in non-domestic currencies, two separate values of the IRR may be computed for each of the three levels which have been described – one to include the effect of exchange rate movements, the other to exclude them. Performance must be calculated with reference to the currency of denomination of the Fund. Should the Private Equity/Venture Capital Managers or Funders so desire, then performance may additionally be calculated with reference to other currencies. Should, therefore, the value of transactions need to be known in both domestic and non-domestic currencies, the exchange rate which prevailed on the date the transaction took place should be used. Where this is not known, the conversion shall be effected using the monthly average exchange rate for the month and year in question.

Realisations

Shares in companies which are floated and distributed in specie should be considered realised upon the earliest date at which such shares may be converted into cash to the benefit of the Funder. It is implicitly recognised, therefore, that shares cannot be regarded as realised whilst any dealing restrictions are in place.

Write-offs should be accorded a nominal value of one currency unit (for example, £1) rather than zero.

As regards the calculation of the Gross Return on Realised Investments only, a written-off investment should be considered as having been realised as soon as the earliest of any of the following or like events takes place: when bankruptcy proceedings are instigated against a Portfolio Company; when a Portfolio Company ceases to trade; when a Portfolio Company enters into arrangements with creditors which result in the investment being written down to zero; when insolvency proceedings are begun.

Investments which have been completely sold subject to a proportion of deferred consideration/earn out should be defined as Realised Investments and an estimate of the discounted proceeds from the deferred consideration should be included in the Realised level calculation. Appropriate disclosure should be given.

When reporting performance measurement of any of the three levels, the cost of the realised investments relative to the cost of all investments made should be given.

By agreement with the Funders, the Private Equity/Venture Capital Manager may only consider it relevant to report the Gross Return on Realised Investments after a given proportion of the investments, by amount and/or number, have been realised.

Share Exchanges

Private Equity/Venture Capital Companies sometimes exchange part or all of their stake in a Portfolio Company for shares in another company. Where such an exchange takes place, the new shareholding should be treated no differently than if it was part of the shareholding in the original Portfolio Company.

Taxation

Dividend and interest payments and capital gains received from Portfolio Companies that are paid net should be grossed up so as to be treated as pre-tax cash flows for the two measures of Gross Return, but not for the Net Return.

Timing of Cash Flows

The date attributed to each cash flow should be taken to be the first day of the month in which it occurred.

Young Investments

Care should be taken in measuring financial returns from recent investments and young funds. Nevertheless, to facilitate the computation of IRRs relating to these investments at an appropriate time in the future, the prerequisite data (cash flows and their timing), should be continuously collected.