Numbers that lie: ESG metrics and TVPI

In the third part of our four-part series on private equity metrics, PEI looks at the dangers of unregulated reporting and why the total-value-to-paid-in multiple only tells half the story.

An illustration of two dice

ESG metrics | The unknown quantity

ESG reporting is still unregulated and the GP decides “which frameworks and standards to follow, which stakeholders to address and which information to make public”, according to a recent McKinsey report.

The subjectivity makes many LPs uneasy, a large North American LP tells us.

Many GPs engage external agencies to carry out their ESG performance measurement. This can create potential misuse. “How will the LP figure [out whether] the external agency is functioning like an internal auditor or presenting numbers the GP wants?” the LP asks.

“You don’t normally see people going out and creating reports, highlighting the negative part of the equation, unless they are focused on reducing that”
Brian Gildea, Hamilton Lane

Moreover, while GPs are happy to talk about the positive impacts their portfolio company had – such as creating jobs or addressing the rise in demand for housing – almost no one talks about negative impacts, such as the amount of effluent being discharged into groundwater, according to a family office LP.

“You don’t normally see people going out and creating reports, highlighting the negative part of the equation, unless they are focused on reducing that,” Hamilton Lane’s head of investments Brian Gildea says.

The problem is the industry has not gotten to the bottom of how to measure ESG, according to Sam Robinson, managing partner of Singapore-based family office North-East Private Equity and former head of regional private equity fund investment at Aberdeen Asset Management.

“I’ve had at least two conversations about how to aggregate these metrics,” he says. “The better GPs are starting to have a slide in their annual reports that says what they’re doing, but everyone uses different things and a PowerPoint slide is not an Excel spreadsheet.”

Indeed, executives and investors both rated “inconsistency, incomparability or lack of alignment in standards” as the most significant challenge in ESG reporting, the McKinsey report notes.

Pension systems such as Texas Municipal Retirement Fund and Alaska Permanent Fund Corp don’t have ESG policies, but pay attention to governance and will not invest in anything that has an obvious negative environmental or social impact.

What should LPs do? “Compile a list of ESG metrics that are most important to you,” the family office source says. LPs can compare those metrics with previous years’ numbers, and even if they are unable to assign material value to the changes, LPs can gauge the intangible changes year on year.

“That tells them the GP is committed to improving the health of all stakeholders in their fund,” the family office source says.

TVPI | Only half the story

TVPI – or the ‘total-value-to-paid-in’ multiple – is a popular and relatively simple gauge of investment performance, but it is not bulletproof. The metric is calculated by adding together the distributed-to-paid-in capital and the residual-value-to-paid-in capital, or the fair market value of a fund’s remaining assets.

One way of boosting the TVPI on an individual deal is by treating a temporary return of capital – a recapitalisation – as a reduction on the original investment cost. For instance: a GP makes a $100 million investment in a company and an early recap returns $25 million. Instead of the $25 million counting as a distribution, it is offset against the original investment, meaning the original contributed capital is marked as $75 million.

“We’ve seen a 2x deal become a 10x deal,” says one LP, who complains that partners were asking her why a deal in which they had co-invested seemed to be returning them a lower multiple than it returned the main fund.

Sam Robinson, of North-East Private Equity, cautions also that TVPI only tells half the story. “Say a GP sells the company quickly and recycles it against calls, the investor only ever put in 50 percent net of their commitment, so it’s only 3x TVPI on that 50 percent rather than the full amount.

“It’s more cosmetic: you naturally think I’ve made 3x on a $10 million commitment, but actually you made 3x on $5 million because that’s all they needed to draw down.”