DealLawyers.com Blog

According to this MiddleMarket.com article, while limited partners in PE funds have historically looked to IRR as the key metric in determining investment decisions, a sharp decline in distributions over the past two years has caused many to shift their focus to a different metric. This excerpt explains:

For years, limited partners have relied on a metric known as internal rate of return — a measure of gains on future cash flows — to determine whether to back an investment. That standard worked when cash was cheap. Now, investors are zeroing in on a different yardstick.

So-called distributed to paid-in capital — the ratio of cash generated to what’s invested — has overtaken IRR as the most critical metric for investors. It’s gaining traction in the aftermath of higher borrowing costs and a dearth of deals, which hindered the ability of buyout shops to exit investments and return money to investors.

The focus on cash returns is ratcheting up pressure on private equity firms to deliver in a tough dealmaking environment. While distributions always had a role when investors evaluated investments, “it’s just gone from maybe the third number you look at to the first,” said Andrea Auerbach, head of global private investments at investing consultancy Cambridge Associates.

The article says that this shift in priorities is the result of a “distribution drought” that’s plagued private equity for the past few years. It points out that distributions by the five major publicly traded alternative asset managers have plummeted 49% since 2021, and the distribution yield for U.S. private equity firms totaled 9% in 2023, well below the 22% average over the past 25 years and the lowest level since the 2008 financial crisis.

– John Jenkins