Alternative investments—which encompass any investment besides stocks, bonds, and cash—are rising in popularity as a way to help build diverse portfolios. Because alternatives are relatively illiquid—meaning they can’t easily be converted to cash—and unregulated by the United States Securities and Exchange Commission (SEC), they often move in the opposite direction of traditional investments, making them a wise diversification strategy for investment portfolios.
The field of alternative investments comprises a wide variety of investment types, and being able to analyze the performance of each requires a different set of metrics and knowledge.
Private equity is no exception. Here’s a breakdown of what private equity is and the necessities for analyzing private equity investment performance.
What Is Private Equity?
Private equity is the category of capital investments made into private companies. In this context, equity refers to a shareholder’s stake in a company and its value after all debt has been paid.
There are three key types of private equity strategies:
- Venture capital: Investment in a promising startup or early-stage venture
- Growth equity: Investment in an established, growing company
- Buyouts: Investments in mature companies by outright purchasing them or one of their divisions
The most common way to get involved in private equity investing is to become a limited partner at a private equity firm. A limited partner is an individual investor who contributes money (typically a minimum of $25 million) to a firm to invest with the promise of returns within a specific period. General partners are individuals who manage the investments of limited partners and decide which companies to invest in.
Investing is a game of give and take; each investment type has risks and rewards to consider. Because the outcome of an investment is based on a private company’s growth, the time horizons for private equity investments are relatively long. With these long time horizons—typically no less than 10 years—investors can mitigate some risk but need to wait to access returns. Traditional investments, such as stocks, are highly liquid, meaning they can be traded in for cash at any time—but they’re also highly volatile.
In the online course Alternative Investments, Harvard Business School Professor Randolph Cohen comments on the difficult nature of investing and the need for performance analysis.
“It’s awfully difficult to select which funds to invest in without having a systematic way of forming an opinion of which funds will do well in the future, or at least knowing which funds had good performance in the past,” he says. “It turns out that performance evaluation is actually quite tricky.”
To make matters trickier, each investment type has its own metrics to measure performance. When it comes to private equity, there are four key factors to consider: context, internal rate of return, multiple of invested capital, and public market equivalent.
Related: What Is Arbitrage? 3 Strategies to Know
Context Is Key
Regardless of which private equity strategy you use, understanding the context of an investment is crucial to analyzing its performance.
“Context is the key to understanding performance analysis,” Cohen says in Alternative Investments. “It turns out that you can’t really know whether a fund really exceeded expectations until you know the surrounding factors.”
To understand an investment’s context, you need extensive knowledge of the receiving company’s industry and market. For this reason, many private equity firms require general partners to specialize in two or three industries. This narrowing of focus allows each general partner to commit to learning the nuances of their assigned industries, track new developments, and gain hands-on experience over time.
All industries, however, experience market fluctuation. As such, it’s useful for each general partner to specialize in more than one so they can switch focus as some markets boom and others bust.
Related: What Is Distressed Debt Investing?
Private Equity Performance Measures
The three measures of private equity performance you need to know are internal rate of return (IRR), multiple of invested capital (MOIC), and public market equivalent (PME). It’s important to learn and use all three metrics in tandem because they account for the others’ blind spots. Together, they create an informed picture of your investment’s performance.
It’s important to note that none of these metrics consider underlying investment risk. To help account for this, make sure you compare investments of the same investment strategy type so the risk profile stays relatively constant.
1. Internal Rate of Return
Internal rate of return (IRR) is the implied annual rate of the return on an investment. When applied as a discount rate, IRR causes the net present value of the investment to be $0.
Think: How fast did I see a return?
This metric overvalues early returns and undervalues an investment’s other qualities, such as total return and the market’s state at a given time.
For example, imagine you’re deciding which of two investment funds performed better. Fund A delivers a $10,000 return every year for 10 years, resulting in a $100,000 total return. Fund B, on the other hand, returns a total of $200,000 at the end of 10 years, but no returns are granted before that date.
According to IRR, Fund A is the better-performing private equity fund. But that doesn’t capture the full picture.
2. Multiple of Invested Capital
Multiple of invested capital (MOIC)—also called multiple of money—is the final amount of money divided by the initial investment, or an investment’s net total return.
Think: How much money did I make in total?
MOIC doesn’t take time horizon or market fluctuation into consideration and overvalues a high total return.
In the previous example, MOIC considers Fund B the better-performing fund, despite not being able to access the money until the 10-year mark. Even then, there’s a factor left out of the analysis: timing in the broader market.
3. Public Market Equivalent
Public market equivalent (PME) is a measure of how close a private equity investment’s performance is to that of the same investment made into a public stock market during a specific period.
Think: If this investment were made into the public stock market during this timeframe, how much would it be worth?
PME is a useful metric to include in your analysis because it considers the timeframe and state of the economy. A useful example from Alternative Investments prompts investors to consider two investment funds with the same IRR and MOIC, but Fund A will see returns in 2004, while Fund B will see returns in 2009. The global economic downturn in 2008 makes Fund A worth much more than Fund B, and using PME is a way to measure that difference.
Diversifying Perspectives
Just as a strong investment portfolio is diverse, so is strong investment analysis. By approaching your private equity investment performance analysis with IRR, MOIC, PME, and industry context, you can understand how quickly your investment saw returns, how much the investment returned in total, and how the private equity investment compared to public investments at the same point in time.
You can then use this analysis to predict how future private equity investments in the same industry and of the same type could perform.
If you’re interested in gaining the skills to both construct portfolios and analyze performance for various alternative investment types, consider taking an online course like Alternative Investments.
Are you interested in expanding your knowledge of private equity and other alternative investments? Explore our five-week online course Alternative Investments and other finance and accounting courses.
