DPI to IRR: How LPs are Changing the PE Performance Conversation
According to kia@axios.com (here), PE is facing a significant challenge: difficulty exiting investments quickly enough to satisfy LPs, causing widespread tension in the industry. (Also, hedge funds have been impacted, as LPs—in particular large institutional investors—are withholding capital due to the scarcity of PE exits. Source: Financial Times)
PE firms currently hold $3.2 trillion in unsold assets and have $4 trillion in available capital, often referred to as "dry powder." (Source: Axios) However, exits and transactions involving "sponsor-to-sponsor" or "secondary buyouts" (where one PE firm sells a portfolio company to another PE firm) are scarce. General partners (GPs) in PE firms today are reluctant to sell high-performing businesses due to the difficulty in finding equally profitable new investments.
LPs are hesitant to commit more capital to GPs who haven't made cash-on-cash returns. The conversation has shifted from internal rate of return (IRR) to distributed to paid-in capital (DPI). The backlog in deployment and exits is significant after two years of weak activity, and the recovering IPO market could help alleviate the exit problem.
DPI measures actual returns to LPs, unlike the future value focus of IRR. Funds raised between 2019-2022 have an average DPI of 0.12X, far below the desired 1X. (Source: Axios) There is a significant gap between ultra-successful firms raising large amounts and many firms struggling to meet targets. Sponsor-led deals are up 38% in value year-to-date, despite a decrease in the number of deals. The market shows momentum with large public-to-private deals.
The PE industry is grappling with a slowdown in exits, affecting LP relations and fundraising. DPI has become the critical measure of performance, reflecting actual returns rather than potential future gains.
In mid-2024, while your mileage will vary, startups shouldn't count on PE firms as likely sources of funding or acquisition. GPs in PE firms are currently reevaluating their market positions and strategies. This reassessment means that PE firms are likely to be more cautious and selective in their investments, focusing on their existing portfolios and more stable opportunities. As a result, in the short term, startups might find it challenging to attract concrete interest from PE firms—they may express cavalier interest—and should explore alternative funding sources or acquirers.