One of the keys to understanding, and investing, in private equity is to understand the nature of the performance, its measurement and characteristics, and how you might expect it to perform in your portfolio.
Two core elements of private equity performance are responsible for much of the mystery surrounding the issue. One is the so-called J Curve; the other is the use of IRR, or Internal rate of Return rather than the more familiar time-weighted rate of return.
The term J Curve describes the return pattern for a private equity fund. In the early years, the costs typically exceed the return, so that when the return stream for the life of the fund is graphed, there is a downward trend in the beginning before the returns begin to come through and the return line turns up. Front end costs exceed revenue because the General Partner (the manager of the fund) is busy searching out and evaluating potential transactions for the fund in the first couple of years.
Much of the total return from private equity comes from the ability of the General Partner to add value to the portfolio companies. This takes time, so even after the investments have been made there may be little short term income. The bulk of the return comes when the investments are realized later in the life of the fund, usually through either an IPO or a sale to a strategic buyer.
The IRR is an annualized effective compounded rate of return calculated using monthly cash flows, annual valuations and realizations. The IRR calculation includes the timing of cash distributions to the limited partners (realized IRR) and how long an investment has been held (unrealized IRR) relative to when the capital was called to make each investment.
Also commonly used is MOC (multiple of capital contributed), sometimes referred to as an exit multiple. This measures the proceeds of an investment that has been sold, relative to the original cost. This does not take into consideration the length of time between investment and realization.