We need to talk about DPI

Capital at risk. T&Cs Apply. Nothing in this article constitutes investment advice. —

When assessing fund performance, the benchmark metric is the Internal Rate of Return (IRR) – the annual rate of growth that an investment has generated. This is typically calculated either net or gross of fund fees.

The nature of IRR means that you can compare funds of different vintages (whether one, five or 10 years’ old, all funds have an IRR) and stages (a pre-seed fund is more likely to deliver a 10x return on capital in absolute terms than a pre-IPO fund, however, pre-IPO exits should be far quicker and as such, may be comparable on an IRR basis).

IRR is also a useful metric to measure returns when they’re still ‘on paper’ rather than having been paid to investors. 

However, as Howard Marks of Oaktree Capital Management famously opined – “You can’t eat IRR”.

This is where Distributed to Paid-In Capital (DPI) comes in.

What is DPI?

Distributed to Paid-In Capital measures the cumulative proceeds returned by a fund to investors relative to paid-in capital.

For example, if you were to invest £100k into a fund via Sprout, and you received £300k of cash once the fund was fully distributed and all companies had exited, your DPI is 3x.

In this example, the fund is fully paid up; however, DPI can be measured throughout the life of a fund, often being 0x in early years and increasing as portfolio companies exit and capital is distributed to investors.

Why is DPI important?

When it comes down to what most people are looking for out of an investment, financial returns will likely be high up the list. It could be argued therefore that DPI is the purest measure of financial returns – cash back in investors’ pockets.

Over the past 5 years, we’ve seen a multitude of new fund managers turn up and generate strong early metrics in terms of MOIC (money on invested capital) and IRR, with portfolio companies raising follow-on rounds at attractive valuations which may have been boosted by the buoyant market in 2021 and 2022.

While the track record may look promising, there is no guarantee that a strong valuation in a growth market leads to a great exit for the fund. Without DPI, we therefore don’t know how “real” the funds’ returns are.

At Sprout, we are naturally cautious of ‘paper returns’. They are directionally useful, but can always move in any direction up until the point of exit. We like the managers that we work with to have evidenced track records of DPI.

Is all DPI made equal?

At Sprout, we talk about “Good DPI vs Bad DPI”. But what does this mean?

In essence, it’s about sustainability of the investment thesis and repeatability of returns & process.

When diligencing a fund which has shown strong DPI in its previous funds, it’s important to understand a number of factors:

  • How many investments provided the DPI (one, or many?) and does this fit in with the thesis (see our blog on the Power Law);
  • Were the exits in previous funds utilising the same thesis as in the current fund (for example, if the new fund is climate tech focused, but the previous big winners were in fintech, is this repeatable?); and
  • Whether the exit was fundamentally overpriced…and potentially lucky. For example, in the recent SPAC market, we’ve seen many venture backed companies with big exits lose >95% of their share value, which implies that the investors’ returns were inflated due to market mechanisms.

The pitfalls of DPI

While an important metric, DPI does have some limitations:

  • It doesn’t take into account inflation or the time value of money. A 3x DPI is the same whether this was paid out in 10, 15 or 20 years; however, the longer the distributions take, the higher the opportunity cost may be for the investor; 
  • While the fund is still active, DPI doesn’t take into account how the fund’s current (active) portfolio companies are performing; 
  • It is imperfect to use as a benchmarking tool for funds with varying theses as they may be targeting different returns profiles based on the risk profile of the fund (sector, stage, geography etc); and
  • In the first few years of a fund’s life cycle, DPI will likely be 0. This will not reflect on the quality of the fund, but the nature of a long term asset class.

Adding context to metrics

Venture capital funds are in the business of making money and therefore DPI is an important metric to use as a starting point to provide context to track record over a longer period of time. However, it’s important to use this in conjunction with other key metrics including IRR and MOIC, as well as assessing other important factors in assessing the potential success of a fund.

This is the reason why Sprout developed the 10 Ts framework. In the same way that you can’t eat IRR, there’s more to choosing funds than DPI.

Capital at risk. T&Cs Apply. Nothing in this article constitutes investment advice. —