DPI Replaces IRR as Key Metric in PE Amid Exit Slowdown

At the recent IPEM conference in Paris, buyout executives underscored a significant shift in PE strategy. With rising interest rates suppressing deal activity and asset valuations, PE firms are increasingly focused on distributions to paid-in capital (DPI) as the new key performance metric. Historically, internal rate of return (IRR) was sacrosanct, with fund managers aiming for high annual returns, often targeting around 25%. However, the industry is now prioritising actual cash returned to investors over theoretical future gains.

This pivot comes as PE firms are holding onto portfolio companies longer, struggling to exit in a market where higher interest rates have squeezed valuations. Globally, PE firms are sitting on an unprecedented backlog of over 28,000 unsold companies worth more than $3 trillion. This accumulation of unsold assets is a direct result of higher borrowing costs making traditional LBOs less profitable. As a consequence, distributions to limited partners (LPs) have dwindled, leaving these investors with less capital to allocate to new funds, putting pressure on fund managers to return cash.

The focus on DPI over IRR is particularly critical now as the fundraising environment is bifurcating. Smaller funds (under $100 million) have raised a meager $1.8 billion in the first half of 2024, compared to $7.7 billion in all of 2023, while “megafunds” ($5 billion+) continue to thrive, raising over $156 billion during the same period. This disparity highlights how smaller, less differentiated funds are struggling to raise capital, while larger funds, often with diversified strategies and stronger reputations, are still able to attract significant commitments.

MY ANALYSIS

In my view, this shift toward prioritising DPI represents a pragmatic response to market realities. The prolonged holding periods and reduced exit opportunities demand a focus on liquidity for LPs, as they need to see tangible returns on their investments. While IRR remains an essential measure, especially for long-term performance, the current environment necessitates a greater emphasis on the actual capital being returned.

Moreover, this change might also lead to a rethinking of fund strategies. We could see more buyout firms exploring alternative liquidity solutions, such as secondary market sales or structured deals, to return capital to investors. This trend underscores the adaptability of private equity, but it also raises questions about how sustainable high returns will be in an environment where exits are delayed, and valuations remain pressured.

Ultimately, the shift to DPI highlights a fundamental tension in private equity: balancing the need for high returns with the necessity of maintaining LP confidence through steady distributions. As interest rates remain elevated, this dynamic is likely to define the private equity landscape for the foreseeable future.