Measuring Private Equity Returns
For several years now, there has been much controversy over how investment performance is measured in the private equity world. In an economy increasingly clouded by uncertainty, investors need to know that returns for a prospective investment are an accurate measure of performance. As capital continues to flow into private equity, it is more crucial than ever to ensure that PE firms are offering clarity and transparency to investors as they tout returns.
What’s the Problem?
Unlike the public markets where a myriad of benchmarks make performance tracking and analysis relatively consistent, private markets are more challenging to accurately compare from one investment to the next. In an attempt to provide consistency in tracking fund performance, internal rate of return (IRR) has largely been adopted as the industry standard financial metric. For many, IRR has become the only metric of consequence when determining the strength of a prospective investment. Perhaps unsurprisingly, a one size fits all performance metric is too good to be true. While IRR is an extremely helpful metric that allows for time-weighted comparison of investment returns, it is not without its flaws.
The flaw most commonly pointed out in the blanket use of IRR is that it can be easily manipulated. Because IRR is so sensitive to the timing of inflows and outflows of cash, it is relatively easy to adjust cash flows to inflate IRR. The most frequent method used by many PE firms to accomplish this is the utilization of subscription lines of credit. Sub lines, as they’re often called, are debt vehicles that allow PE firms to delay the deployment of investor capital. By financing a transaction for 6-12 months (and sometimes longer) with debt rather than invested capital, IRRs can be skewed higher despite no additional returns being generated by the investment. Theoretically, an investor could test 2 nearly identical investment opportunities, with the only difference being one uses sub lines and the other doesn’t. On the surface, the investment that utilizes sub lines will appear to be a much more lucrative deal when in reality both deals are generating the same returns.
Since Inception IRR
Another problematic nuance of IRR is the emphasis many firms place on “since inception IRR”. For private equity firms that have been around for decades, highlighting their since inception IRR is a solid marketing tactic, but it is lacking in sound financial basis and is often misleading to investors. By nature of its calculation, IRR places more value on returns generated towards the beginning of an investment period and diminishes value placed on cash flow. As a result, the since inception IRR for established funds is unlikely to change over time no matter what the recent performance of the fund has been. So, somewhat counterintuitively, for a firm that has been around for decades, touting a since inception IRR of 30% + says very little about what any future investment is likely to yield.
That is not to say that since inception IRR or subscription lines are inherently bad. Sub lines can be exceedingly helpful to quickly close deals in between capital calls, and since inception IRR conveys a strong, if not dated, track record of performance. The heart of the issue is a lack of transparency and an over-reliance on IRR as the be-all end-all of fund performance. Increasingly, the use of sub lines is being disclosed to investors–an encouraging step towards transparency. Additionally, savvy investors, and prudent fund managers, are weighing IRRs against several other return metrics. Testing opportunities across as many data points as possible is the most certain way to ensure the strength of an investment.
IRR is not going away anytime soon. It still offers many benefits and provides a relatively reliable metric for evaluating the performance of a private equity investment. Until an alternative metric is identified that can succinctly capture the time-value returns across a variety of asset classes, it is likely that fund managers and investors will continue to lean on IRR as the performance metric of choice. As with most things in life, balance is key. Too much emphasis on IRR will inevitably lead to poor investment, but there is no need to completely do away with a metric that can be very informative.