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Designing a Phantom Option Plan for an NBFC
Every investor receives a fund performance summary at year-end containing four metrics: IRR: 18%, TVPI: 2.3x, DPI: 0.6x, and RVPI: 1.7x
The immediate question follows: which metric matters most?
All four matter, but none can be relied upon independently.
Each performance metric captures a different aspect of fund returns and has limitations when assessed independently. General Partners may selectively emphasize the metric that presents their fund in the most favourable light, highlighting TVPI for funds with significant unrealized gains, IRR for mature funds with uneven distributions, or vintage-year comparisons for weaker performers.
Limited Partners who understand the strengths and limitations of each metric are better positioned to evaluate true performance. A balanced assessment of all key measures helps ensure that strong headline figures do not obscure underlying weaknesses.
Before analysing each metric individually, we must establish what they collectively measure.
The fundamental question: Did my capital investment generate returns?
The three metrics answer this from distinct angles:
Consider a concrete scenario: You invested $100M in 2015. As of 2025, you have received $250M in distributions plus the fund values your remaining position at $80M.
Each metric communicates essential but incomplete information about performance. Collectively, they form a comprehensive assessment.
Definition: IRR is the discount rate that reduces the net present value of all cash flows to zero. Stated differently, it is the annualized return that accounts for the timing of capital deployment and recovery.
Importance: IRR functions as the standard metric for comparing fund investments across asset classes and time periods. A 20% IRR objectively outperforms a 12% IRR, all other considerations equal. It is the primary tool institutional LPs use for return comparisons.
Assume the following cash flows:
Total capital deployed: $15M ($10M + $5M) Total distributions received: $43M
The IRR accounts for the uneven timing of these flows. Capital deployed in Year 0 works for 9 years. Capital deployed in Year 2 has 7 years useful life. Distributions begin in Year 5, enabling potential reinvestment. The calculation integrates all these temporal elements and produces an IRR of approximately 17%.
Why is timing meaningful? Because the same total return achieved over different periods yields different annualized rates. IRR captures this distinction.
IRR's sensitivity to cash flow timing creates a substantial vulnerability. Consider two scenarios where both investors achieve identical multiples (2x) over five years, but the timing differs:
Scenario A: $1M invested, $0.5M returned in Year 3, $1.5M returned in Year 5. Scenario B: $1M invested, entire $2M returned in Year 5.
Despite identical multiples and timeframes, Scenario A produces a higher IRR because capital recovery occurred earlier, creating reinvestment opportunity. The IRR difference reflects timing advantage, not superior fund performance.
This creates a problem: a fund can achieve attractive IRR figures through fortunate timing of early exits—not necessarily through superior investment acumen.
The J-curve describes the typical performance trajectory of a private investment fund. It begins negative (due to management fees and early position write-downs), gradually recovers, and finally accelerates as exits materialize and distributions increase.
The implication is profound: IRR measurement at different points in the fund's lifecycle produces dramatically different apparent performance from the identical portfolio.
For venture capital funds from the 2021 vintage:
The portfolio composition did not change. The J-curve maturation did. Yet an investor evaluating the fund at Year 3 would observe entirely different apparent performance than an investor evaluating it at Year 6.
This is why IRR-based comparison must account for fund maturity and J-curve positioning. Comparing a Year 4 fund to a Year 8 fund based on IRR alone introduces substantial distortion.
Formula: Distributions Paid to Investors ÷ Capital Paid into Fund
Example:
The investor has recovered $1.50 in actual cash for each dollar invested. This represents realized value.
Why DPI Matters: DPI is the most objective metric. It is unambiguous. Either the fund distributed cash, or it did not. There is no valuation interpretation required. There are no mark-ups or mark-downs. There is no temporal assumption. It reflects actual, verifiable distributions.
For risk-conscious institutional investors, DPI is often the primary performance metric. Unrealized value can evaporate. Only distributed cash is inviolable.
2017 Vintage (approximately 8 years old as of 2025):
This indicates that the typical VC fund from 2017 has distributed back approximately $0.27 for every dollar invested. Most of the value remains unrealized in the portfolio.
2015 Vintage (approximately 10 years old):
2020+ Vintage (6 years or younger):
High DPI may reflect favourable exit timing rather than fund excellence. A fund experiencing one or two large exits in early years will show outsized DPI relative to overall performance quality. Conversely, a high-quality fund with later exit timing may show depressed DPI relative to its underlying portfolio quality.
Diagnostic Question: "What is the composition of my DPI? Is it concentrated from a few mega-exits, or distributed across numerous exits?"
A concentrated distribution pattern suggests timing-dependent performance. A distributed pattern suggests repeatable, systematic execution.
RVPI (Residual Value to Paid-In) measures the value of investments that have not yet been exited, relative to the capital contributed by investors.
Formula:
Residual (Unrealized) Value ÷ Capital Paid into the Fund
Example:
Total capital deployed by investor: $10M
Current unrealized portfolio value: $12M
RVPI: $12M ÷ $10M = 1.2x
This indicates the investor has $1.20 of estimated remaining value for every dollar invested that has not yet been distributed. Unlike DPI, RVPI represents mark-to-market valuations based on the most recent pricing of portfolio companies, internal valuation models, or comparable transactions.
RVPI reflects the embedded upside still held within the fund. It provides insight into future distribution potential and the manager’s ability to generate exits at or above current carrying values. For earlier-stage funds, RVPI often comprises the majority of total value. However, RVPI is inherently subjective. It depends on valuation assumptions, market multiples, financing conditions, and company-specific projections. Unrealized value can appreciate — or compress — before liquidity events occur.
Early fund years (1–3): RVPI is typically high relative to DPI, as most capital remains invested and unrealized.
Mid-fund years (4–7): RVPI may peak as portfolio companies mature and receive follow-on valuations, while DPI begins to increase from initial exits.
Late fund years (8–10): RVPI declines as assets are liquidated or written down. Ideally, RVPI converges toward zero as DPI approaches TVPI.
Formula: (Distributions Paid + Residual Value of Holdings) ÷ Capital Paid Into Fund
Alternatively: TVPI = DPI + RVPI
Example:
The fund has generated $2.10 of total value creation per dollar invested. Of this, $0.60 has been realized as distributions, and $1.50 remains in the portfolio as unrealized appreciation.
TVPI provides meaningful perspective during a fund's middle years, indicating whether value creation is occurring independent of realized exits. A TVPI of 1.5x after five years represents reasonable progress. A TVPI of 1.0x after five years raises performance concerns.
2017 Vintage:
2019 Vintage (approximately 6 years old):
2021 Vintage (approximately 4 years old):
Beyond the primary three metrics, two supplementary measures occasionally appear:
MOIC is typically calculated at the investment or portfolio company level, representing total proceeds divided by capital invested in that specific position.
Example: $5M invested in Company X; exit proceeds of $18M; MOIC = 3.6x.
MOIC is valuable for tracking individual investment performance. For fund-level analysis, TVPI remains the standard metric.
The J-curve represents the characteristic performance arc of private investment funds. Understanding this dynamic is essential for metric interpretation.
A fund's apparent performance depends substantially on the measurement point within the J-curve.
Evaluation at Year 3: The fund appears problematic. Evaluation at Year 8: The same fund appears exceptional. The portfolio has not changed. The J-curve progression has.
Empirical Data: For 2021 vintage VC funds, median IRR remained negative through Year 3. By Year 6, the median IRR turned positive and material. The funds did not fundamentally change—the J-curve maturation altered apparent performance.
Consequence for LP Analysis: Avoid comparing funds at different J-curve positions. A Year 4 fund and a Year 8 fund cannot be fairly evaluated on identical metrics. Vintage year cohort comparison is the appropriate framework.
Portfolio company valuations are marked quarterly by fund managers. Mark-ups increase reported valuation; mark-downs decrease it. Mark-ups comprise a significant source of RVPI (unrealized gains). However, these valuations are discretionary—there is no independent price discovery mechanism.
Year 1: $10M invested in Company X. Marked at $10M cost basis.
Year 2: Company X raises an external funding round at a higher valuation. The fund marks up to $15M. RVPI increases.
Year 3: Company X has not achieved the fundamentals justifying the higher valuation. However, the mark remains at $15M. TVPI appears strong in marketing materials.
Year 5: Company X exits at $12M. The fund's mark was $15M. Reality: 20% lower than the recorded valuation.
This pattern is common, not exceptional. Research indicates that median venture capital unrealized gains experience 40% downward revision upon exit.
A fund reporting TVPI of 2.5x with:
...is claiming that 84% of value remains on paper. If the empirical 40% markdown materializes at exit, the true ultimate TVPI would approximate 1.7x, not 2.5x.
This is why TVPI must be analyzed together with DPI composition and the defensibility of remaining valuations.
When allocating to a new fund, employ this systematic comparison framework:
Both funds must originate from approximately the same calendar year. Comparing a 2015 fund to a 2019 fund should terminate this analysis immediately. You are comparing incomparable entities.
DPI is the most objective metric. It reflects actual distributions. If Fund A exhibits 0.8x DPI and Fund B exhibits 1.2x DPI within the same vintage, Fund B has returned more actual capital.
However, investigate concentration: Did Fund B achieve 1.2x DPI from one mega-exit? Or from consistent execution across the portfolio? Consistency is more repeatable.
TVPI indicates total value creation. However, the composition matters critically.
Fund A: TVPI 1.8x; DPI 0.8x; RVPI 1.0x
Fund B: TVPI 2.2x; DPI 1.2x; RVPI 1.0x
Fund B demonstrates superior progress because a higher percentage is confirmed through distributions. It carries lower clawback risk. Its gains are more defensible.
At this stage, you have already comprehended the multiple and composition. IRR serves as a supplementary lens.
Fund A IRR: 14% Fund B IRR: 16%
Fund B demonstrates advantage across multiple dimensions: superior multiples, higher realized percentage, and higher IRR. The choice clarifies.
For RVPI >1.0x, ask: "How much unrealized gain derives from mark-ups versus from third-party funding rounds at higher valuations?"
Mark-ups are subjective and at-risk. Funding rounds represent price discovery and are more reliable. If the majority of unrealized gains derive from mark-ups, the RVPI is materially at risk.
PME compares your fund's return to S&P 500 performance over the identical period. This grounds the analysis in reality.
If a fund achieved 14% IRR but the S&P 500 returned 16% over the same period, the fund underperformed public alternatives. Why accept private equity illiquidity for inferior risk-adjusted returns?
Sophisticated LPs consistently calculate PME. It provides essential perspective.
All previously discussed metrics represent gross returns (before management fees and carry).
Actual investor proceeds reflect net returns—after the GP extracts 2% management fees and 20% carry.
Example:
A fund's gross metrics:
Following deduction of 2% management fees (10-year life) and 20% carry:
The differential is substantial. Gross 22% IRR appears exceptional. Net 14% IRR is median.
Standard Practice: Always obtain net returns from GPs. Request net TVPI and net IRR after comprehensive fee and carry deduction. Refusal to provide this analysis is a significant red flag.
Experienced LPs employ this analytical framework:
Gross returns are irrelevant. Net returns—after all fees and carry—matter exclusively. If net IRR falls below 12%, the opportunity is rejected.
By year 5-6, meaningful distributions should be evident. DPI of 0.3x or below raises liquidity and execution concerns. Either the fund has not exited (illiquidity risk) or exits have underperformed (performance risk).
What percentage is confirmed through distributions? High TVPI with primarily unrealized gains is high-risk. Confirmed value is preferable.
Is this fund performing relative to its cohort? Top quartile? Bottom quartile? Peer-relative performance matters critically.
Is performance driven by several mega-wins? Or distributed across the portfolio? Broad distribution indicates repeatable, systematic execution. Concentration suggests timing-dependent outcomes.
For unrealized value: what proportion derives from portfolio company funding rounds (more credible) versus manager mark-ups (less credible)?
Does this fund beat the S&P 500 on a time-weighted basis? If not, why accept illiquidity for underperformance?
What is the timeline to full capital deployment? Funds slow to deploy destroy value through extended management fee accrual on uninvested capital.
What is the typical investment-to-exit timeline? Extended hold periods (10+ years without clear rationale) destroy value through fee drag.
When the GP raises the follow-on fund, what narratives predominate? Genuine track record documentation? Or marketing emphasis? Track record presentation is more credible.
Three metrics. Three complementary perspectives. Together, they form a comprehensive assessment of fund performance.
IRR quantifies annualized returns but is sensitive to cash flow timing and J-curve positioning. TVPI measures total value creation but depends on subjective unrealized valuations and is vulnerable to mark-up discretion. DPI reports actual distributions—the most objective metric but incomplete without knowledge of remaining portfolio composition.
When all criteria align, a strong fund is identified. When metrics demonstrate selective strength in a single dimension—be skeptical. The GP is likely emphasizing metrics precisely because other dimensions are weak.
Comprehensive metric literacy prevents being misled by selective presentation and enables rigorous, systematic fund evaluation.
It depends entirely on vintage year and fund type. For a 10-year-old fund, 2.0x is acceptable but not exceptional. For a 5-year-old fund, 2.0x is solid. For a 3-year-old fund, 2.0x is strong but likely represents substantial paper gains. Always evaluate within vintage context.
This suggests front-loaded performance. The fund distributed cash aggressively early but the remaining portfolio is weak. It is a warning signal. It indicates performance clustering in early exits rather than sustainable systematic returns.
Mathematically impossible. TVPI equals DPI plus unrealized value. DPI cannot exceed TVPI. If observed, data reporting error has occurred.
Conservative analysis assumes 40% markdown at exit based on empirical research. Assume RVPI of 2.0x will ultimately realize as 1.2x. This is conservative but protects against surprise write downs.
Context is essential. If the fund is seed/early-stage VC, zero DPI at year 5 is normal (extended hold periods are expected). If the fund is PE, zero DPI at year 5 is concerning (exits should be materializing).
Yes, systematically. GPs emphasize the metric presenting their fund most favorably. Young funds emphasize TVPI (largely unrealized). Underperforming funds emphasize vintage cohort ranking (rather than absolute performance). Lumpy distributions create illusions of consistent performance. Always demand complete metric disclosure.
Substantially. If a fund's 14% IRR underperforms the S&P 500's 16% return, the fund has destroyed relative value despite positive absolute returns. This comparison grounds evaluation in opportunity cost rather than absolute returns alone.
