The rule of 72 in the context of private equity is a mental-mathematical shortcut used by investors to estimate the time it takes for an investment to double at a specified annual rate of growth. This is a simple yet effective formula that has become essential in the hands of decision-makers, VCs, and other professionals in the private equity field, as they require estimates of performance without needing to perform complex calculations.

Understanding the Rule of 72 Formula

The rule of 72 is straightforward; you divide 72 by your projected annual rate of interest (as a percentage) to calculate the number of years it takes for your investment to approximately double. The mathematical expression is:

Years to Double = 72 / Annual Rate of Return (%)

For example, when a private equity fund aims to achieve 9% per year, one would have to divide by 9, which corresponds to an estimated doubling period of 8 years. This formula originated in 1494 when Italian mathematician Luca Pacioli first documented it in his work Summa de arithmetica, making it one of the oldest financial calculation methods still widely used today.

How Does the Rule of 72 Work in Private Equity?

To understand how the rule of 72 operates, one must grasp the concept of compound interest. The rule of 72 investment plan is based on exponential growth, where a single dollar grows exponentially and generates additional returns over time. At Nexus Expert Research, our private equity research services often use the Rule of 72 to analyze investment prospects and forecast realistic growth timelines.

When valuing potential fund investments, the doubling period formula is applied in the back-of-the-napkin calculations made by private equity professionals. When a limited partner invests $200,000 in a fund with a forecasted Internal Rate of Return (IRR) of 12%, it can be predicted that in 72/12 = 6 years, the investment will have doubled (the rule of 72).

The rule is also reversed in that, in case you wish to multiply your investment over a given duration, you can divide 72 by the number of years you wish to have to know the rate that you need to get. An example is that, in 10 years, doubling capital would require an average annual growth rate of 7.2% (72/10 = 7.2).

Applications in Private Equity Performance Metrics

The rule of seventy-two complements traditional private equity performance metrics, such as IRR, TVPI (Total Value to Paid-In), and MOIC (Multiple on Invested Capital). While these metrics provide accurate calculations, the Rule of 72 offers rough estimates during deal negotiations and portfolio reviews.

Quick Performance Estimates

PE professionals take advantage of this rule in quick assessments of the trajectories of fund performances. The doubling period formula is a useful tool to compare various investment opportunities and prioritize investments that offer more favorable growth timelines.

Benchmarking and Goal Setting

The rule helps in setting expectations and comparing potential returns with those of other asset types. For small to medium-sized businesses and startups that require private equity funding, understanding this concept is very useful for structuring realistic discussions about growth with potential investors.

Fee Impact Assessment

The Rule of 72 investing principle helps you understand the effects of management fees on net returns. If a fund has 2% annual charges and earns an 8% gross return on its investments, the net return may be 6%, and thus the doubling time increases from 9 years (72 / 8) to 12 years (72 / 6). This highlights the importance of the fee structure.

Advantages for Private Equity Investors

The rule of 72 formula has a number of advantages which make it useful for decision makers and VCs:

• Simplicity: Mental calculations are a good way to avoid the use of financial calculators during meetings or negotiations.
• Speed: Rapid estimates allow the rapid comparison between several investment opportunities.
• Accessibility: The concept of compounding is easy to understand due to its straightforward nature.
• Flexibility: It can be applied not only to investment returns but also in determining the cost of debt, the impact of inflation, and the cost of funds.

Nexus Expert Research emphasizes that, even as sophisticated financial models are still necessary for making final decisions, the Rule of 72 is an invaluable first-pass screening tool.

Limitations to Consider

Although the rule of seventy-two is applicable, the following are significant limitations that private equity professionals must not ignore:

• The formula is most effective with an annual return ranging between 6% and 10%. The accuracy of exponential growth is reduced at high rates, which is typical of successful PE investments.
• The rule presupposes the same annual returns, which is hardly the case in the volatile private equity market, where performance is wildly uneven.
• Additionally, the doubling period formula is only applicable to compound interest calculations, not simple interest calculations.
• The analysis of irregularly compounded and unevenly distributed cash flows in private equity investments would require more advanced analytical tools.

Alternatives and Variations

For different scenarios, alternative rules provide better accuracy. The Rule of 70 works better for lower return rates (2%-5%), while the Rule of 69.3 proves most accurate for continuous compounding models. Adjusted rules using 71, 73, or 74 as the numerator can improve precision at rates significantly above or below 8%.

Practical Implementation

At Nexus Expert Research, the Rule of 72 concept is often applied in our investment due diligence research to evaluate growth potential and assess realistic return timelines. The Rule immediately indicates performance expectations by implying that, in the case of a private equity fund targeting 15 percent annual returns, the doubling interval is 4.8 years (72 / 15 = 4.8).

Savvy investors would also employ this Rule, as well as holistic measures such as DPI (Distributed to Paid-In) and PME (Public Market Equivalent), to examine performance comprehensively.

Conclusion

The 72-rule in private equity is an eternal shortcut calculation for investments, even though it was derived from mathematics in the 15th century. For decision-makers, VCs, and businesses operating in the private equity environment, learning to master the Rule of 72 is a competitive advantage in high-speed negotiations. Although it can never substitute for due diligence with all its details, this beautiful formula provides instant insight into investment timelines and assists professionals in making better decisions on the allocation of capital.

In case you are willing to make smarter investment choices, book consultation about private equity strategies in Nexus Expert Research to get a one-on-one consultation.