October 7, 2021

Private Equity: Is IRR a Misleading Metric?

There’s a new study out that slams private equity funds’ lack of transparency and the metric typically used to measure their performance. The study says that reliance on “internal rate of return,” or IRR, as the Holy Grail of fund performance is potentially misleading and an impediment to determining whether these funds outperform the public markets. Here’s an excerpt from this Institutional Investor article:

Investors in private equity face high costs and increased risks because of structural issues in the industry that hinder transparency. For example, investors generally don’t measure returns and fees based on information on the underlying portfolio companies. Instead, investors have data, such as cash flows, to calculate what’s called the internal rate of return, or the IRR, of the fund. That means, “the true investment risk within their PE portfolios is largely unknown,” according to the paper.

Measuring performance with internal rates of return also makes it difficult for investors to compare the returns of different private equity funds and to contrast the strategy with what they would have earned in the public markets. Monk and his co-authors argue that the measure is heavily influenced by returns earned early in a fund’s life. As an example, the report cites private equity funds from the 1970s and 1980s, whose returns earned since inception are exceptional because of this property. “This is not only misleading as an indicator of their contemporary performance, but it forms a performance moat around the top private equity firms against which emerging managers and strategies struggle to appear competitive,” wrote the authors.

The authors argue for the use of what they refer to as “organic finance” to assess PE investments.  The authors characterize organic finance as “an emerging investment philosophy underpinned by greater information transparency between investors and the sources of investment return (base assets).”  The key to organic finance is greater transparency when it comes to providing investors with the data needed to calculate valuations, returns, risks, fees, performance attribution, and other performance categories of base assets.

Sounds great in concept, but right now investors don’t seem real interested in analyzing whether investments in PE funds really make economic sense.  According to this PitchBook article, money is pouring in to private equity – particularly into “mega funds” raising more than $5 billion. What’s the attraction?  PitchBook analyst Rebecca Springer says it’s their IRR:

When it comes to the question of whether mega-funds generate better returns, she said that overall, they have beaten smaller funds in recent years. “They are less likely to underperform and less likely to overperform relative to smaller funds,” she said. The resonating shockwaves of the pandemic are still being felt throughout private equity. Springer said the surge in mega-funds isn’t a COVID-19-specific trend, but that the pandemic probably did give the funds a tailwind.

“Mega-fund IRRs (internal rates of return) bounced back more quickly than smaller fund IRRs after Q2 2020. The larger portfolio assets of mega-funds may have been more resilient to pandemic effects and are more likely to be marked-to-market against public company comps, which meant these funds shared in the stock markets’ rapid recovery,” she said.

The authors contend that IRR is an illusion when it comes to appropriately assessing PE fund investments.  If so, it’s one that private equity investors seem to find pretty comforting right now.

John Jenkins