The following is adapted from The Private Equity Playbook.

If you want to invest in private equity, it starts with picking the right partner. Like most things in life, it matters whom you partner with! Some firms and funds perform better than others, so it’s important to know the metrics that help you, as a limited partner, gauge the potential success of each private equity firm’s funds.

History is never a guarantee of future success, but it can be an indicator.

There exists a ranking system for private equity funds, and just like for mutual funds, these rankings are generally done by independent institutions.

There are three key individual rankings. Instead of being rated by stars, they are separated into quartiles. A top quartile is the top 25%, second quartile is 25–50%, third quartile is 50–75%, and the fourth quartile is in the bottom 25%.

Funds are ranked against each other by vintage (the year of a fund’s first investment) in order to isolate general background economic trends or conditions that might have impacted performance of all funds of one era versus another. This is the only way to look at relative head-to-head performance of various private equity funds. There is no overall combined quartile ranking; rather, each ranking is rated separately.

In this article, we’ll walk through the three ways private equity funds are ranked.

Ranking #1: Internal Rate of Return

The most important ranking is the internal rate of return (IRR), which is the net return earned by limited partners over a particular period and expressed as a percentage (%). The calculation itself is very complicated, but at a high level, the number takes into account all of the various cash flows going in and coming out, including capital calls, management fees, carried interest fees, and distributions.

The IRR is time dependent and uses the present sum of cash contributed, present value of distributions, current value of unrealized investment, and then a discount is applied.

The IRR value is important to a limited partner because he is tying up a portion of money for an extended period, with the inability to invest that capital elsewhere. If the average rate of return in the stock market over time is 7% per year, then the limited partner is losing the ability to earn that same percentage if he was to invest in a total stock market index fund over an extended period. Thus, the IRR of the private equity fund better be higher than 7% net of all fees and carried interest.

IRR is important, but you can’t spend it. It’s not cash!

However, IRR is the number one litmus by which private equity funds are rated.

A good IRR is typically in the mid-teens, around 14–15% in today’s world net of all fees and carried interest charges. A great IRR is higher than 20%.

Because there has been a huge growth in private equity, there is a lot more money chasing deals. Prices paid for companies have gone up, and the amount of return has gone down. Private equity firms are underwriting investments a little bit lower than they used to because of the competition. That dynamic can change over time, just like a buyer’s market and seller’s market when it comes to housing. There is currently nearly $1 trillion in capital looking for investments, but the private equity funds’ IRR continue to outpace typical stock market returns, and thus, the entire industry continues to grow.

Ranking #2: Multiple on Invested Capital

The next number to consider is the multiple on invested capital (MOIC). This is simply the return divided by the invested capital. It’s a secondary measurement to IRR but this is the cash return. Whereas you can’t spend IRR, you can spend MOIC.

The difference is that MOIC does not take into account the hold period.

If you invest $1 million and get a return of $3 million, that’s a 3x MOIC. However, it can take one year or ten years to see that return, and there’s no way to measure that impact with this particular metric. An investment that returned 3x MOIC in three years would have a higher IRR than one that returned it in seven years. Same cash return but a vastly different IRR. That’s why you look at both measurements!

Ranking #3: Distributions to Paid in Capital

The final ranking is distributions to paid in capital (DPI).

The DPI measures the ratio of money that is distributed by the fund against the total amount of money paid into the fund. At the beginning of a fund, DPI is zero. As distributions are made, the fund breaks even with a DPI of one.

DPI is more useful when comparing new or active funds of the same vintage, as the DPI will ultimately be near or equal to the MOIC after a fund is fully matured. On an active fund, the DPI showcases the velocity of how fast the fund is returning money to shareholders at the various stages of its ten-year life span.

To Recap: Get a Full and Accurate Measure

These three measurements are somewhat interrelated. Limited partners use all three to come up with an opinion about the private equity firm, how a current fund is performing, and how the firms’ historic funds have performed in the past.

IRR is most important, MOIC is next, and then last comes DPI.

Limited partners may consider the funds of 5,400 different private equity firms to invest in, so they need some means of knowing the difference between funds.

They may be considering venture capital funds, buyout funds, fund of funds, or different verticals, such as healthcare or technology. They may seek to build a portfolio of investments with different kinds of private equity firms and funds, but they need these rankings to help differentiate and make decisions on where to invest.

As an individual, you’ll have a hard time finding these ratings without subscribing to an industry service. For the purposes of this article, I just wanted you to know that these ratings exist and, with a little effort, can be accessed before investing.

For more advice on choosing the right private equity partner, you can find The Private Equity Playbook on Amazon.

Adam Coffey has spent the last twenty years as president and CEO of three national service companies: Masterplan, WASH Multifamily Laundry, and now CoolSys – all of which were owned and sold multiple times by private equity firms. Known for building strong employee-centered cultures, and for executing a buy and build strategy, Adam is highly sought after by private equity and is considered an expert in running industrial service businesses. He is a former GE executive, an alumnus of UCLA, and a veteran of the United States Army.