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Private Capital Risk, Returns, and Benchmarking

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As you know from the previous lessons, alternative assets have the potential to offer higher returns than traditional investments such as equities and fixed income. This has attracted investor attention in recent years, and alternatives now make up a significant proportion of many investor portfolios. That said, the alternative assets industry is still relatively immature; it is important that investors understand the unique characteristics of these investments, including differences in how risk and returns are calculated and reported.

One of the defining characteristics of private capital investments is the irregular timing of cash flows between investors and fund managers. Investors will typically give and receive capital at intervals and in varying amounts, with capital being requested by fund managers as needed to fund new investments, and money being returned to investors over time as those investments are exited. This means measuring returns and benchmarking across asset classes can be a challenging exercise for investors. As a result, the industry has adopted a number of different performance measures: internal rate of return (IRR), money multiples (TVPI, DPI, and RVPI), and public market equivalent (PME). Let’s explore each of these in more detail.

Internal Rate of Return (IRR)

The IRR is a measure of return on investment. Expressed as a percentage, the IRR is based upon the realized cash flows and the valuation of the remaining interest in the partnership. It is an estimated figure, given that it relies upon not only cash flows but also the valuation of unrealized assets. IRR can be expressed as gross or net of fees and carried interest – net IRRs tend to be the most commonly used metric.

The early years of a fund’s life are characterized by net cash outflows and negative returns, resulting from the loss of expenses incurred during the fund’s formation and the deployment of capital into portfolio companies or assets. Eventually, the fund will see cash inflows as it begins to generate a return on its investments. Once they have matured, the fund manager can begin to exit the companies or assets invested in, with capital being returned to investors.

An IRR calculation has the following pros and cons:

  • Incorporates the time value of money in the calculation 
  • Relatively easy to calculate, interpret, and compare
  • Impractical implicit assumption of the reinvestment rate
  • Gaming/manipulation is possible: i.e., early distributions can disproportionately boost IRR

J-Curve Effect

As most private market investments are not valued or traded frequently, it is a challenge for allocators to make sure they benefit from the higher expected returns, but also to keep their exposure within a certain range. It is therefore beneficial to monitor the cash flow pacing and value to determine if an investment allocation is on target. 

The ‘J-Curve’ effect is used to describe the way private equity funds’ net cashflows are often negative in the early years, before increasing and turning positive in later years. In the first few years of the fund, negative returns are typically experienced due to the associated fees of investment, management, and the portfolio's immaturity. The fund’s net cashflow begins to increase in the later years when investments begin to mature and are eventually realized, in the form of distributions.

Benchmark pacing models such as the J-Curve, using the internal rate of return, can help analyze the cash flows and value of a private market’s portfolio in relation to a broader portfolio of assets. This in turn helps the industry anticipate returns and accurately predict or manage cash flows.

Below are some ways the J-Curve is currently used in industry:

  • The model demonstrates the cashflow pacing behavior of managers. For example, how much capital – and at what points do they call/distribute – over the lifetime of a fund.
  • It also helps potential LPs understand whether the cadence and size of a manager’s calls and distributions will be feasible in the context of their total portfolio’s cashflow schedule. 
  • Drives greater efficiency when managing capital calls and re-investment decisions.

This model creates an effect known as the ‘J-Curve,’ seen here.


Multiples are another metric used to measure returns for private capital investments. Expressed as a multiple (e.g. 0.5x, 1.2x, 2.0x), they look at the proportion of capital invested vs. the amount returned to investors. There are three types of multiples typically reported by funds:

  1. Distribution to paid-in ratio (DPI)

    Also called realized return, DPI concentrates on distributions back to investors, comparing them to the sum of capital contributions made by investors. The calculation for DPI is as follows:

    DPI = Capital Returned to Investors / Capital Called

  2. Residual value to paid-in ratio (RVPI)

    Otherwise referred to as unrealized return, RVPI focuses on the ratio of the residual value of assets owned by the fund (using current valuations) to capital paid in by investors. The equation for RVPI is:

    RVPI = Net Asset Value (NAV) / Capital Called

  3. Total value to paid-in ratio (TVPI)

    Also called total return, TVPI is the sum of a fund’s distributions and residual value of assets, divided by paid-in capital.

    TVPI takes into account the returns that would be achieved if unrealized assets were sold at current valuations and distributed back to investors, while also considering capital already returned to investors. TVPI therefore provides a more comprehensive view of returns against just DPI, although using current valuations for unrealized assets may not provide an accurate picture for future returns. TVPI is calculated as follows:


    At the start of a fund’s life, TVPI and RVPI are both in deficit due to net cash outflows and negative returns, while DPI is zero since no capital has been distributed back to investors. In the early years, both TVPI and RVPI begin to grow as the fund manager starts to deploy capital into assets and the value of assets held by the fund increases. After year three, the fund manager begins to exit some of the investments and RVPI begins to shrink as the residual value of assets held falls. By contrast, TVPI increases and DPI also starts to grow as money begins to be distributed back to investors. When DPI is equal to one, the fund has broken even, as money paid in is equal to money distributed; any number above this indicates that the fund has distributed more capital than has been paid in.

The chart below provides an illustration of how these metrics change over a typical 10 year fund lifespan.

Public Market Equivalent (PME)

The final performance measure considered in this lesson is PME, which provides investors and fund managers with a method for benchmarking the returns of a private capital fund against the return of a chosen public market index.

Comparison to a public index allows both investors and fund managers to review the relative performance of their investments. For investors this is an important exercise, helping to inform portfolio allocation decisions and to evaluate the performance of one asset class against another. For fund managers this can form a key aspect of fund marketing activities, helping to showcase fund outperformance and to secure capital commitments from investors.

The key obstacle here, however, is that private capital returns are not directly comparable with public market indices due to the illiquid nature and irregular timing of cash flows. The industry often uses the analogy of ‘comparing apples with oranges’ in relation to this difficulty. To address the issue and provide a more meaningful, like-for-like comparison with the market, PME was developed.

PME metrics benchmark the performance of a fund, or a group of funds, against an appropriate public market index while accounting for the timings of fund cash flows. There are several variations of PME. Preqin’s PME tool enables the comparison of private capital returns against seven public market indices using a choice of three PME methodologies explored in more detail below: Kaplan-Schoar PME (KS PME), Long-Nickels PME (LN PME), and PME+. Click through the metrics below to find out the calculations involved in each of these PME methodologies, and their advantages and disadvantages:

In this lesson, we explained more about cash flows, and how they affect measurement of risk and return for private capital investments. We then took you through the different types of performance measures used by industry participants, from IRR to J-Curve, multiples, and PME.