From www.bvca.org. BVCA copyright.
Measuring Performance: The Internal Rate of Return
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
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
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
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
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.
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
Commitments made by a Funder to a Private Equity/Venture
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.
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.
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.
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
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
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.
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.