DPI or die?

How are LPs' focus on DPI shifting?

^{As exits have slowed, a lack of distributions has been causing LPs some serious headaches. It’s no wonder that so many are now focusing on returned capital in their discussions with GPs. But is this having unintended consequences?}

There is no doubt that liquidity has been in short supply in private markets over the past two years. Deployment in private equity has clearly slowed since the massive run-up to 2021 and 2022, when buyout houses globally invested $2.3trn and $1.8trn, respectively, (versus $1.4trn in 2023), according to PitchBook figures.

Yet the downturn in exits has been much sharper: in 2021, private equity firms realised $1.7trn; in 2023, this had fallen to $744bn. Venture capital is in a similar position. All this translates into a lot of capital stuck in the system, LPs facing capital calls they may struggle to meet, and fundraising becoming a tougher slog than usual.

It's hardly surprising, then, that LPs have focused on distributions to paid in capital (DPI) over recent years when talking to existing and prospective GPs. But has the pendulum now swung too far? And could this be skewing incentives and behaviour among some GPs? Here are some perspectives from both sides of the LP-GP camp.

The shift to DPI could be here to stay. “DPI isn’t new – Howard Marks wrote the famous line that ‘you can’t eat IRR’ 20 years ago,” says Christoph Landolt, Investment Manager at Multiplicity Partners.

“That’s exactly what’s happening now. You have these fantastic paper IRR gains, but investors are not getting any money back, so perceptions are changing. IRR becomes relevant in more mature funds when investors have received a lot of capital back, but for a younger fund with low DPI, IRR isn’t relevant. It’s all paper gains based on what can be subjective valuations, even if the auditor does say they are true and fair. Investors need to cover their capital calls, after all.”

It’s a question of balance. “The venture capital market was heated in the period to the end of 2022 and there are now a lot of stranded assets,” says Pamela Fung, Partner at Morgan Stanley Private Equity Solutions.

“LPs are now chasing down for DPI, which puts GPs in a difficult position. If you have a great asset, it’s capital efficient and it’s still growing, it might be a sub-optimal time to sell right now as you may not achieve a great price, but the pressure is on. GPs need to be given the discretion to manage that, but in the current environment, it may be hard to strike the right balance.”

With LPs focusing on DPI, GPs are being asked to focus on exits

Weichou Su, Partner, StepStone Group

But GPs need to be open with their investors. “With LPs focusing on DPI, GPs are being asked to focus on exits,” says Weichou Su, Partner at StepStone Group. “Yet we have to be realistic: it’s a challenging environment and so they won’t be able to realise investment immediately. However, they can be transparent and keep communication open. GPs need to come forward and own what’s happened rather than keeping quiet.”

Be careful of what’s left in the portfolio. “I think the way the conversation is going around DPI is problematic,” says Joel Sandhu, Partner at TTA Capital & Investors Capital.

“It’s great that it is focusing GPs’ attention on exits, but there is a danger that what’s happening is giving a false sense of security to investors. We see some great headline exits from our portfolio from 2020 to 2022 investments, but there is a sense that some GPs are selling the stars because they have to show something to their LPs.

My fear is that there may be fundamental problems in the rest of the portfolio, where companies are perhaps struggling. DPI is important, but it’s more helpful to look at the entire fund portfolio, the value creation and where the companies are marked.”

Overall fund performance still matters. “DPI is important, but IRR is still the number one metric,” says Liam Coppinger, Head of Private Equity Asia at Manulife Investment Management.

“If you decide to do the work on assessing a manager, you have to evaluate the source and the quality of the DPI as well as the quality and outlook of the remaining assets. There may be positions that you want to hold longer because they’re compounding winners. GPs need to be focused on managing the fund because fund-level returns are what matters. All too often, I find that managers talk to us about specific deals rather than fund performance, even though that’s what we care about.”

History serves as a useful lesson. “Private equity managers are extraordinarily creative and resilient,” says Michael Barzyk, Global Head of Private Equity at Allstate Investments.

“If we wind back the tape a decade or so, the hot issue wasn’t DPI, it was net IRR. So what happened? Subscription lines of credit went from 30 days to 360 days, which artificially increased IRRs to satisfy LPs.

In today’s environment, NAV loans and continuation vehicles are the equivalent of that – LPs are asking for money back and these mechanisms appease investors. The point is that not all DPI is created equally. The way I view it is as a kind of hierarchy: NAV loans are lower quality DPI than continuation vehicles, which are lower quality than secondary buyouts, which are lower quality than trade sales.”

There may be positions that you want to hold longer because they’re compounding winners. GPs need to be focused on managing the fund because fund-level returns are what matters

_{Liam Coppinger, Head of Private Equity Asia, Manulife Investment Management}