Evaluating private equity’s performance: Approach the “value bridge” with caution

Evaluating private equity’s performance: Approach the “value bridge” with caution

Introduction

Pension funds and other private equity 
investors pay high fees to the private 
equity firms that manage their money. (In 
this article, “private equity” refers only to 
buyouts.) How high? It is hard to capture 
this in one figure, but four of the largest 
private equity firms now file reports with the 
US Securities and Exchange Commission 
(SEC), which give some indication. Table 
1 shows that, since 1976, fees and carried 
interest have cost investors in these 
managers’ funds between 7 percent and 
14 percent per annum.
 These four 
managers have historically received 
between one-quarter and one-third of the 
gross returns that they generated.
People who work in private equity — both 
fund managers and investors — say that 
although these costs are substantial, 
they represent good value, and not just 

because investors receive high returns. 
How the returns are generated is even 
more important. Private equity sees itself 
as a cut above the rest of the investment 
pack. Where most investment managers 
generate returns through some combination 
of market timing and/or stock picking, private 
equity says it does something harder and 
more valuable: it ‘creates value,’ meaning it 
makes the overall economic pie bigger than 
it otherwise would be. 
The term “value creation” lacks a clear 
definition. Different people use it to mean 
different things. What this article means 
by private equity value creation is only 
that part of an investment return that 
comes from making the economic pie 
bigger than it otherwise would be. This 
embraces a full range of familiar private 
equity strategies: for example, running a 

single company more efficiently, growing 
it faster, breaking up a conglomerate, 
creating bigger groups through a buy-and-

build approach, and so on.
Private equity value creation in this sense 
excludes several items that are regularly 
referred to as “value creation. These 
include a general market increase in 
profits, market timing, stock picking and 
financial engineering. The returns that 
come from these sources are real enough. 
Such returns will help pay for pensions 
over the long term. But they do not come 
from making the economic pie bigger than 
it otherwise would be. 
Private equity managers charge higher 
fees than traditional investment managers. 
To justify this, private equity managers 
should be able to demonstrate that their 
investments have outperformed. Merely 
matching the performance of non-private 
equity companies does not support 
incremental fees. Therefore, this article 
distinguishes private equity value creation 
from value creation generally. The latter 
comprises the overall change in value, 
while the former reflects the incremental 
performance relative to non-private 
equity peers.
The two most-familiar measures of 
return in private equity are the internal 
rate of return (IRR) and the cash multiple. 
These measures of overall return both 
fail to distinguish between what would 
have been achieved anyway and what 
can be attributed to private equity. The 
result is that neither the IRR nor the cash 
multiple is very helpful when it comes to 
measuring private equity’s value creation. 
A private equity investment may generate 
a high overall return (measured as IRR 
or cash multiple) without involving any 
value creation at all by private equity. If the 

profit has come from a general increase 
in profits, market timing or financial 
engineering, then the economic pie is no 
bigger as a result of this investment than it 
would have been otherwise.
Private equity claims it creates value by 
running companies better. That makes 
it essential to measure accurately what 
proportion of private equity returns does in 
fact come from running companies better. 
This article therefore looks behind headline 
return figures such as IRR and cash multiple. 
Two broad approaches to breaking down 
the overall return in private equity are 
available. The one that appears to be 
most widely used is known as the “value 
[creation] bridge.”
 The mathematics and 
the accounting in the value bridge are 
accurate and it is useful in some ways. 
However, it fails to give an accurate picture 
of how much of private equity’s returns 
come from running companies better.

Evaluating private equity’s performance: Approach the “value bridge” with caution