How Do Private Markets Work?

Imagine walking down an endless road that looks exactly the same. There are no breaks in the endless blank line merging into the horizon, and there are no indicators to tell the distance.

No matter where we are, or what we are doing, it is very important to have some measure of how well we’re doing or how much value we are creating. Our investments are no different.

In the public market, all you need to check how your investment is doing is to open up your demat portfolio. As share prices are updated every day, you can obtain the latest values.

But what about the private markets? How can fund managers in the alternative investment space measure the performance of their portfolios?

Let’s find out the details in this chapter.

In the private markets, funds are generally structured in a simple manner. The limited partners commit capital. And the general partners invest that capital to generate returns.

This means, there is an overall accountability that needs to be maintained. GPs have to share some details about the portfolio’s performance from time to time. Having a clear and transparent measure of how the investments are doing is very important.

The portfolio companies also need to be accountable. The whole premise of the investment is based on the fact that these companies can create value in the future. There needs to be clear growth milestones to ensure that the projected timelines are maintained.

Apart from that, alternative assets can sometimes be volatile. For instance, startups can have immense growth potential. But if left unchecked, things can often go wrong.

Internal Rate of Return

The internal rate of return is one of the most popular performance measures in the private markets. It takes into account the reinvestments at different points in time. This means, that even if the capital gets partly distributed or if there is a new capital call, the performance measure does not get skewed.

On the flip side, the IRR is also the discount rate at which the net present value of all future cash flows becomes zero.

To find the IRR, we equate the Net Present Value (NPV) of cash flows to zero and solve for the discount rate. The formula is:

0 = [CF1 / (1 + IRR)] + [CF2 / (1 + IRR)2] + [CF3 / (1 + IRR)3] + …….. + [CFn / (1 + IRR)n]

where,

CF is the cash inflow in a given period
n is the number of periods

For example, let’s assume the fund manager is planning to invest ₹10,00,000 in a startup. The projected cash inflows from the investment over the next three years are:

• Year 1: ₹3,00,000
• Year 2: ₹4,00,000
• Year 3: ₹5,00,000

Using the formula above, the IRR comes up to approximately 18.4%. This means the fund manager can expect an annualised return of 18.4% on their investment over three years. If the required rate of return is, say, 15%, then with an IRR of 18.4%, the investment is quite an attractive one.

IRR is not without its flaws, however.

1. Multiple IRRs
   If there is a situation in which we have alternating positive and negative cash flows, there might be multiple IRRs.
2. Assumption of Reinvestment
   IRR assumes that any future cash flows are also reinvested at the IRR itself. This is not always a very practical assumption to make. The Modified IRR can help solve this problem.
3. Mutually Exclusive Projects
   For large-scale projects with different scales of investment, comparing IRRs might not always yield the right choice. In this case, too, the Modified IRR is a more appropriate choice.

It considers both the cost of the investment and the interest earned on the reinvestment of cash inflows. Essentially, it calculates:

1. The future value of positive cash flows reinvested at the reinvestment rate.
2. The present value of total costs (initial investment and any negative cash flows) at the finance rate.

The rate that equates these two values is the MIRR.

Formula:

MIRR = (FV of Positive Cash Flows at Reinvestment Rate / PV of Costs at Finance Rate)^(1/n) — 1

Where n is the number of periods.

Let’s consider the following example of an investment with the following cash flow stream:

Initial Investment: ₹10,00,000

Year 1: ₹4,00,000
Year 2: ₹5,00,000
Year 3: ₹6,00,000

Let’s assume that the finance rate is 10% and the reinvestment rate of 12%. This means the future value of the positive cash flows is

Year 1: ₹4,00,000 * (1.12)^2 = ₹5,04,320
Year 2: ₹5,00,000 * (1.12)^1 = ₹5,60,000
Year 3: ₹6,00,000 (no reinvestment needed for the last year)

Total Future Value at end of Year 3 = ₹16,64,320

Since there’s only the initial investment in Year 0, the present value of costs remains ₹10,00,000. Applying the formula, we get a MIRR of approximately 18.7%.

According to CRISIL, venture capital and private equity funds showed good returns. Among the 74 surveyed venture capital funds, the average IRR was 21.15%. As for the 91 private equity funds, they yielded an average IRR of 19.34%.

The net present value, very simply, measures how much the company is worth in today’s terms. It calculates the difference between the present value of cash inflows and the present value of cash outflows. NPV is an absolute measure of the projected profitability of the startup.

NPV is a very simple and direct measure. As long as the NPV is positive, it means that the projected earnings from the investment are greater than the costs involved.

NPV is also used, as a performance measure, in the capital budgeting process to prioritise projects.

To calculate NPV, we find the sum of all the discounted future cash flows and then subtract the original investment from it.

NPV = ∑ {CF / (1 + r)^t} — C0

where,

• CF is the cash flow in time period t,
• R is the discount rate,
• T is the time period and
• C is the initial cost

Let’s consider an example.

A private equity fund is planning to invest ₹1,000 crores in a renewable energy startup. The project is expected to generate cash inflows of ₹300 crore, ₹350 crore, and ₹400 crore over the next three years. The fund uses a discount rate of 10% to account for its cost of capital and risks.

Using the formula above, the calculated NPV comes up to approximately ₹6.49 crore.
As the NPV is positive, this means it can be considered a good investment.

This is more of a relative measure. The Multiple on Invested Capital or Multiple of Money compares the amount the Limited Partner gets after distribution with the initial investment amount.

If the investment grows to ₹10,000 crores from ₹1,000 crores, then the MOIC is 10x.

MOIC = Current Value of Investment / Initial Investment

It quantifies the return on an investment relative to the initial amount invested. Unlike ROI, which expresses returns as a percentage, MOIC presents returns in terms of multiples.

MOIC is popular because of its simplicity. It is a straightforward measure and it offers absolute clarity on how much the investment has grown. It is also quite a standardised metric and can be used to compare different investments.

This is similar to MOIC. But instead of just considering the amount that is distributed, it also takes into account any residual amount that is retained by the private market fund.

TVPI measures the total value generated by an investment relative to the total amount of capital paid into it. It offers a holistic view of how much the investment is currently worth for every unit of capital invested.

TVPI = (Residual Value + Distributions) / Paid-In Capital

where,

• Residual Value is the current value of the investment
• Distributions represent any returns already realised and given back to investors
• Paid-In Capital is the total amount of capital invested

When TVPI is equal to one, the total current value of the investment is equal to the initial capital invested. Any TVPI value greater than one means the investment is worth more than the initial amount. A value lesser than one implies a loss!