Updated with corrections
Evidence is mounting that internal rate of return — the way investors and private equity firms measure return — provides a flawed view of performance.
If two recent academic papers are correct, IRR makes returns look better than they are.
The average performance measured by IRR gives an optimistic view of average private equity fund performance, said Oliver Gottschalg, associate professor of strategy and business policy at the Paris-based HEC School of Management.
In one of the first studies of private equity fund performance done after the financial crisis, Mr. Gottschalg, found that only top-quartile funds outperformed equally risky stocks and provided sufficient alpha to make up for private equity's illiquidity and unpredictable cash flows. The paper further found that the traditional approach measured by IRR as compared to the stock market is “inaccurate and misleading.”
Mr. Gottschalg is also head of research at Peracs Ltd., a provider of quantitative analytics for private equity fund due diligence. His paper, “The Historic Performance of Private Equity: Average vs. Top Quartile Returns. Taking Stock after the Crisis,” was released by Peracs and eFront, a software solutions provider for the alternative assets industry that provided much of the data for the research.
“The private equity asset class on average yields only minimal and statistically insignificant alpha,” Mr. Gottschalg wrote in the paper, released last month. His findings were based on an analysis of 701 US and European buyout funds with an aggregate fund size of $360 billion over the seven year period ended mid-2010.
IRR places a lot of weight on a fund's earliest years. In his study, Mr. Gottschalg showed that a fund that earned an 80% IRR in year two could have lost a dollar amount equal to two times the fund's size in year 10 and the fund's IRR would have only dropped by a percentage point or two over that same time span.
“It's mind boggling that investors still use IRR,” Mr. Gottschalg said in an interview.
“I've been in the (private equity) market for 20 years and so I was not shocked” by the results of the study, said Eric Bernstein, chief operating officer of North America in the New York office of eFront.
However, industry data providers say there's a good reason to stick with IRR.
“Private equity is essentially a cash-flow game, so IRR is the best way of looking at returns for most investors that will set an allocation in terms of how much capital they expect to have committed to the asset class in order to assess its performance,” stated Tim Friedman, spokesman for Preqin, a London-based alternative investment research firm.
But IRR returns may differ greatly from actual returns, said Ludovic Phalippou, a lecturer at the Saïd Business School, University of Oxford, in an interview.
The IRR methodology can generate very large returns while the true underlying return might be close to that of public equity, noted Mr. Phalippou, who is the author of a separate paper also released in June, “Why is the Evidence on Private Equity Performance So Confusing.”
The paper uses Yale University's endowment as an example of how stellar private equity returns based on IRR might exaggerate true returns. The paper argues the IRR return claimed by Yale since the portfolio's inception is too high to be anywhere close to the actual return and noted the Yale return didn't change much even over a 10-year period that included the economic crisis.
David F. Swensen, Yale's chief investment officer, in a written message included in the $16.7 billion Yale endowment's fiscal year 2010 report, attributed the endowment's overall 10-year return of 8.9% per annum to its alternative investments including private equity. The private equity earned 6.2% per year during the 10 year period ended June 30, 2010.
What's more, Mr. Phalippou's paper finds that industry benchmarks rely on the assumption that net asset value is the same as market value. However, the more conservative an NAV is, the higher the reported performance. So, if past NAVs were conservative and now, because of fair value accounting changes the recent NAVs are closer to market values, then computed returns can be further overstated, the paper finds.
“This is highly significant as the industry performance reports ... are the only source of performance information for an asset class worth over $1 trillion,” he said in an interview.
Contributing to the perceived overstated performance of private equity funds, each of the main performance data vendors have different cutoffs of what they consider “top quartile” funds. And it's not a marginal difference. While Mr. Gottschalg declined to provide the data providers' cutoffs, the range among them can be as much as 10 percentage points, he noted.
Typical comparisons from industry associations and general partners show that over 30 years, aggregate return of private equity beats the aggregate stocks return by a wide margin, Mr. Gottschalg noted. But the IRR used by private equity is only influenced by the earliest time periods, he said. So, for the 30-year aggregate, the outstanding performance of the 1980s affects the returns, he said.
“IRR puts too much weight on the very, very early returns,” Mr. Gottschalg said. “The 1980s were really good and so, it doesn't matter that private equity was losing money in the crisis.”
In his study, Mr. Gottschalg said he corrected for that bias and found that private equity, on average, performed similarly to equally risky public stocks, he said.
Another problem with the standard comparisons is the timing of the cash flows. The equity index return is a passive buy-and-hold index return, but private equity has an irregular pattern of cash flows, which the standard comparison does not take into account, he said.
Also complicating performance comparisons, is that current private equity reporting lacks an exact definition of “vintage year.” Some data providers use the year the fund closed, others use the year the private equity firm began raising the fund and still others use the year the fund received its first cash flows, Mr. Gottschalg said. This is important because each fund in a portfolio is often judged against the IRR of funds of the same vintage year and many investors diversify their portfolios by vintage year.
Mr. Gottschalg adjusted his study to demonstrate the impact of this ambiguity. In his study, he let a group of private equity firms sponsoring some 500 funds select the vintage year of the funds. This included allowing firm executives to move to the next year, either a year earlier or a year later. Of those funds, 76% could claim to be top quartile, he said.
Leading academics already have switched to more advanced methods of measuring private equity performance, he noted. One measure is a modified IRR. Another is the profitability index using a discounted money multiple.
Even some industry executives acknowledge IRR could use a revamp.
“Internal rates of returns tend to distort short-term successes and failures,” noted David I. Fann, president and CEO of PCG Asset Management LLC, a La Jolla, Calif.-based private equity consulting and investment management firm.
PCG Asset Management uses other metrics along with IRR in measuring private equity performance, including total value multiple, which is total value divided by invested capital. The firm also spends a lot of time analyzing the losses in the portfolio and the reasons behind them, as well as on the winners and how those companies create value.
Preqin's Mr. Friedman said that IRR provides a good metric for comparing funds. Measuring performance using net multiples or value multiples has drawbacks, too, he stated.
“I'd rather invest $100 today and get $150 next week than $200 in five years, but value multiple will make the latter look better,” Mr. Friedman stated in his e-mail. “However ... very early positive cash flow returns can make a fund with an average multiple look very strong — that's why investors really need to look at how fund managers are performing across underlying portfolios and examine both value multiples and IRRs at the fund and deal level in order to get the full picture.”
“IRR is ultimately the best metric, but the industry needs to improve reporting in three respects,” said Marshall Sonenshine, chairman and managing partner of New York-based investment bank Sonenshine Partners LLC.
There needs to be consistent reporting calculations, particularly as to valuations of private holdings. The measurement should also include a clear delineation between realized and unrealized returns and valuations of privately held holdings, and private equity performance should take into account the cost of capital calls, he said.
“The industry has never been intellectually honest about the cost of those calls,” Mr. Sonenshine said. “And the LP (limited partner) community has been strangely part of that problem. There is a cost to creating call obligations and illiquid holdings — as anyone who sells an LP (limited partnership) interest at a discount to intrinsic valuation finds out.”
Capital call obligations — having the cash on hand to invest when the general partner calls for it — have a cost, he said. Even so, the industry ignores some of these costs, particularly the call obligation, in discussing IRRs.
“That is a conceptual error that GPs and LPs make,” Mr. Sonenshine said.