A manager of private equity, real estate or natural resources is raising a new fund after several previous funds. As investors, a primary part of our evaluation of the opportunity will be qualitative, but a starting point is usually the manager's track record. For each of his prior funds, the manager will provide the fund's internal rate of return to investors and the multiple of their contributions that they ultimately received. As investors, how should we evaluate those results?
There is no one best way. Each manager's track record should be evaluated in multiple ways, each with a large dollop of qualitative interpretation.
The most common approach for most funds — especially venture capital — is vintage-year comparisons. How did each fund perform relative to similar funds raised in the same calendar year? Theoretically, each fund raised in the same year would have been invested in the same investment climate, facing the same set of investment opportunities. But we must also evaluate how similar are the comparable funds for that vintage year. And how similar were the investment opportunities for funds begun at the beginning or end of that calendar year, or for funds with different investment periods?
There is a tendency for prospective clients to scan the IRRs and develop an impression of their simple average, perhaps adding a judgmental weighting to the IRRs.
Another way — a better way, I propose — is to calculate the average IRR on the manager's previous funds, focusing not on the simple average IRR of the prior funds, but on their duration-weighted IRR That assumes we invested the same amount (say, $1 million) in each fund.
For example, for each fund, we calculate the duration of a zero-coupon bond with the same IRR and the same multiple as that fund, based on the latest date for which performance is available. The multiple is the cumulative distributions plus the remaining value of the fund, divided by all the contributions provided by investors.
A duration-weighted IRR is often lower than the simple average IRR because lower-return funds tend to have longer durations.