For anyone participating in venture capital (VC), the first step to making confident, long-term investment decisions is understanding the key performance metrics for capital vehicles. In this article, we define three essential metrics used in assessing VC fund performance: Total Value to Paid-In (TVPI), Distributed to Paid-In (DPI), and Internal Rate of Return (IRR). For each, you'll learn what the metric represents, how to interpret the data, and how to avoid possible data manipulation.
Total Value to Paid-In (TVPI)
Total Value to Paid-In (TVPI) provides insight into the full value of investments made by a VC fund relative to the total capital contributed by investors. VC firms calculate TVPI as the ratio of the current portfolio value (including realized and unrealized investments) to the total capital called by the VC fund. The formula for calculating TVPI is:
TVPI = (Current Portfolio Value) / (Total Capital Called)
A TVPI value greater than 1 indicates that the VC fund has generated positive investment returns. For example, a TVPI of 1.5 means that for every dollar invested by limited partners (LPs), the VC fund has returned $1.50. Conversely, a TVPI below 1 indicates that the fund still needs to recoup capital invested.
What to Know About TVPI
Because TVPI does not account for the time factor, the metric does not reflect the speed at which a fund's investments generate returns. Additionally, VC firms can calculate TVPI based on gross or net figures. As expected, the two calculations provide a different perspective on the fund's performance.
Gross TVPI considers the portfolio's total value without accounting for any management fees, carried interest, or other expenses deducted by the VC firm. It is a precise measure of a fund's investments without considering any deductions. The formula for calculating Gross TVPI is:
Gross TVPI = (Total Portfolio Value) / (Total Capital Called)
Net TVPI is the same general equation but accounts for management fees, carried interest, and other fund expenses. For that reason, net TVPI is a more realistic representation of actual returns that LPs are likely to receive and a better metric for investors who are concerned about the impact of fees on total returns. The formula for calculating Net TVPI is:
Net TVPI = (Total Portfolio Value - Total Fees and Expenses) / (Total Capital Called)
Interpreting TVPI
TVPI is a valuable metric for providing a comprehensive snapshot of a VC fund. It is most reliable as a measure of:
- Realized and unrealized investments in the fund over time
- The performance of the entire portfolio
- Insight into diversification and the success of individual investments
The metric is less reliable for an investor who is seeking to understand the actual value of a fund because it less effectively addresses:
- How valuation fluctuations might impact unrealized investments
- The impact of the timing of cash flows
- The variance in returns between investment stages in the fund (early-stage, growth, late-stage)
How TVPI can be Manipulated – and What to do About It
As you're assessing TVPI, keep in mind a few possible manipulations. Don't hesitate to ask the VC firm to explain how they calculate each.
TVPI is a valuable metric for assessing a VC fund overall. Investors also need to consider DPI and IRR performance for a comprehensive understanding of a fund.
Distributed to Paid-In (DPI)
Distributed to Paid-In (DPI) measures the amount of capital distributed back to investors (LPs) relative to the total money contributed to give insight into the liquidity and realization of returns generated by the VC fund. VC firms calculate DPI as follows:
DPI = (Total Distributions to LPs) / (Total Capital Called)
A DPI value greater than 1 indicates that the fund has returned more capital to LPs than was invested, signifying positive returns. For instance, a DPI of 1.2 shows that the fund has distributed $1.20 for every dollar LPs invest. Conversely, a DPI below 1 means the fund has yet to return the total amount of capital invested, indicating unrealized gains or losses. In other words, a lower DPI suggests that the fund is still in the early stages of its investment cycle or is facing challenges in exiting investments.
What to Know About DPI
For LPs seeking to understand how well a fund returns capital relative to the capital called, DPI is a crucial performance metric. As with TVPI, VCs calculate DPI based on gross and net. Each calculation provides a different perspective of the fund.
Gross DPI considers total distributions made to LPs without accounting for any expenses or fees, so it offers a clear view of total distributions relative to the total capital called. The formula for calculating Gross DPI is:
Gross DPI = (Total Distributions to LPs) / (Total Capital Called)
Net DPI includes the impact of management fees, carried interest, and other fund expenses deducted by the VC, so it is particularly relevant to LPs who want clarity about the effect of fees on overall returns. The formula for calculating Net DPI is:
Net DPI = (Total Distributions to LPs - Total Fees and Expenses) / (Total Capital Called)
Interpreting DPI
Like TVPI, the usefulness of DPI metrics depends on how they are presented. It is a reliable measure of:
- The ability of the fund to generate liquidity and return capital to LPs
- Tangible cash returns for LPs (because this is a cash-focused metric that accounts for actual distributions)
DPI will be less reliable for understanding the fund over the long term and the impact of diversification within the fund because:
- DPI may focus on short-term liquidity, so a fund may show high DPI because it exited investments early, but it may miss higher potential returns gained by holding onto portfolio companies
- DPI doesn't account for the value of unrealized investments that may appreciate, so a fund that shows a lower DPI might still have valuable unrealized investments
- DPI considers all distributions equally, regardless of investment stages in the fund (early-stage, growth, late-stage), even though early-stage investments generally need a longer runway to realize returns
- DPI measures capital returned to LPs rather than the fund's investments, so it is a less complete snapshot of portfolio value
How DPI can be Manipulated – and What to do About It
While DPI is an essential measure of fund efficiency, it is prone to manipulation. Here are a few considerations to assess fund performance.
To round out the performance assessment, let's look at IRR as the third pillar in a comprehensive understanding of fund strategy, performance, strategy, and fee structure.
Internal Rate of Return (IRR)
Internal Rate of Return (IRR) is a metric that shows the annualized rate at which a fund's investments grow over the investment period. Put simply, it is the profitability of a VC investment – making it an essential way for LPs to assess performance and risk. IRR is a complex calculation based on the timing and magnitude of cash flows. Most VCs use sophisticated software for these calculations.
What to Know About IRR
As with TVPI and DPI, a higher IRR indicates superior performance and higher returns, while a lower IRR may suggest subpar performance compared to market benchmarks. It's also vital for investors to assess the consistency of IRR over multiple funds.
As they do with TVPI and DPI, VCs use gross and net figures to calculate IRR. Gross IRR uses investment cash flows without adjusting for management fees or other expenses, generating a total view of investment performance. Net IRR deducts management fees, carried interest, and additional fund-related costs to generate actual investor returns.
Interpreting IRR
Unlike TVPI and DPI, IRR considers complex and fluctuating factors, which play into how well IRR acts as a measure of investment performance.
For considering cash flows and timing, IRR is a reliable assessment of:
- The timing of cash flows, accounting for the size and timing of investments and distributions
- The potential returns of different investments or funds with varying timelines, investment sizes, and cash flow patterns
- Tangible returns realized based on actual cash flows generated by an investment
IRR is less reliable when contextual elements influence returns.
- Because IRR depends on the accuracy of assumptions (e.g., future cash flows, exit valuations, and timing), even small changes in assumptions can impact IRR calculations
- IRR is sensitive to the timing of cash flows, so delays in receiving distributions can impact calculations
- IRR does not account for the size of an investment or capital contributed, so smaller investments might have a higher IRR but lower profits
- Because IRR does not account for risks, it will not offer a complete investment risk profile
- IRR calculations can assume unrealized investments at the end of an investment horizon
How IRR can be Manipulated – and What to do About It
Even though VCs typically calculate IRR using sophisticated software programs, it is susceptible to manipulation. A fund can:
- Artificially inflate IRR by selectively reporting positive cash flows and excluding negative ones or by highlighting distributions and downplaying cash outflows.
- (Temporarily) boost IRR by timing transactions close to the reporting period.
- Neglect to factor in the time value of money, which would (incorrectly) assume that all cash flows are equally valuable.
- Inflate IRR calculations with high exit valuations, revenue projections, or exaggerated future cash flows.
- Prioritize short-term exits to achieve a higher IRR, putting investors at risk of missing out on long-term value creation.
- Buy and sell investments too frequently to create multiple rounds of smaller IRR calculations that might add up to a higher total IRR but fail to create lasting value.
- Report successful exits while ignoring underperforming or unsuccessful exits, making IRR look impressive but not reflective of actual performance.
- Use inappropriate or misleading benchmark rates in IRR calculations to distort comparisons.
As an investor, it's crucial to evaluate IRR with careful due diligence. While the hope is that you are partnering with a VC firm that behaves as a fiduciary to its investors and operates with full data-backed transparency, that may not always be the case. Here is a checklist of things to confirm with any new investment:
- Critically examine assumptions, including exit scenarios, the timing of cash flows, and discount rates.
- Scrutinize assumptions to ensure they are reasonable and not overly optimistic.
- Consider the time value of money and ensure that the calculation aligns with industry best practices for discounting cash flows.
- Request detailed information about distributions and capital calls over the investment's life.
Data and clarity about the fund's investment strategy enable investors to determine whether a fund's IRR aligns with their long-term investment objectives and risk tolerance.
The bottom line is that an informed investor is more likely to be successful over the long term. Understanding the importance of TVPI, DPI, and IRR is crucial to confident investment decisions. With a holistic, data-driven understanding of fund performance and a careful VC partner, investors can make well-informed, confident decisions about the VC firm and its funds.
