The Faulty Metric at the Center of Private Equity’s Value Proposition

Illustration by II

Illustration by II

Internal rate of return isn’t the only metric private equity firms tout. But it’s the major one — and according to industry watchers, it has a serious flaw.




These three words have increasingly been used to describe private equity returns — or at least one popular measure of private equity returns: the IRR.

The internal rate of return measures how a portfolio performs on a dollar-weighted basis and includes the effects of cash flows like capital calls and fund distributions. It has long been used as a performance indicator for private capital funds, which have surged in popularity over the past decade as investors have sought to diversify their portfolios in the wake of the financial crisis.

But although it’s been widely used, IRR has never been a perfect representation of private capital returns. Oaktree Capital Management co-founder Howard Marks has been pointing this out since 2006, when he popularized the phrase “You can’t eat IRR” in a client memo arguing against overreliance on the performance metric. Investment consultants have similarly been telling clients for years to examine not just IRR, but investment multiples, underlying portfolio company earnings, and countless other performance indicators.


Yet despite it all, IRR has remained the industry’s most widely used shorthand for private equity performance, the one highlighted in fundraising pitchbooks and given to pension fund boards and endowment investment committees as evidence of how a portfolio is doing. Andrea Auerbach, who heads up private investments at consulting and investment firm Cambridge Associates, describes the internal rate of return as “the common language with which private investors discuss funds.”

She explains: “It’s never been a number you should just take by itself, but it’s always been a great signifier of where a manager might stand.”

Over the past two years, however, the accuracy of IRR has been called into question thanks to the increasing ubiquity of subscription lines of credit. These loans, also known as commitment facilities, have long been used in the private capital industry to finance transactions before investor capital is called in, easing limited partners’ liquidity needs and making it possible for general partners to jump on deals more quickly. But lately, fund managers have been using subscription credit lines differently — and with greater frequency.

According to alternatives data provider Preqin, the use of commitment facilities among private equity funds has more than tripled in the past decade, with 47 percent of funds launched in 2010 and later having utilized the financing tool, compared with 13 percent of funds launched before 2010. And it’s not just that more private fund managers are taking out these loans. Preqin also reported that these once short-term instruments are now being used to delay capital calls longer — which investors, researchers, and other industry experts claim is leading to artificially inflated IRRs.

“This more aggressive use of commitment facilities has really complicated using IRR as a common language,” Auerbach says. “You have to ask more questions.”

The most obvious question: Are IRRs really being artificially inflated?

The answer, according to an emerging body of academic research, is yes.

Two recent papers — one from a pair of Carnegie Mellon business school professors, one co-authored by two German researchers with a BlackRock private equity director — have explored the effects of subscription credit lines on IRRs and arrived at the conclusion that the loans have meaningfully improved IRRs without increasing the actual amount of money that investors take home.

The German researchers, Pierre Schillinger and Reiner Braun of the Technical University of Munich, worked with BlackRock Private Equity Partners director Jeroen Cornel to simulate how real buyout funds would perform if they had hypothetically used subscription credit lines. Simulating commitment facility use for less than six months resulted in only a 47-basis-point increase in IRR on average, or a 20bp improvement at the median. But increasing the time frame of the loan to a year led to an average IRR bump of 120 basis points — a median increase of 57bp.

“If used extensively, [subscription credit lines] can indeed lift fund returns substantially,” they concluded.

The Carnegie Mellon professors, meanwhile, took the opposite approach, using data provided by private capital analytics firm Burgiss to identify funds that had used subscription credit lines, then calculating how their IRRs would change if the loans hadn’t been used. James Albertus and Matthew Denes, both assistant finance professors at the Tepper School of Business, found that the use of commitment facilities boosted IRRs by 6.1 percentage points while causing a slight dip in the total value to paid-in multiple, or TVPI, due to managers’ paying interest on the loans.

Speaking to Institutional Investor, Albertus and Denes emphasized that the current version of their paper — “Distorting Private Equity Performance: The Rise of Fund Debt” — is a first draft, and that they plan to conduct further analysis with a larger sample size and a methodology that includes additional performance metrics, like PME, the public market equivalent. But even their early findings make a compelling case that subscription credit lines do, in fact, inflate IRRs.

“It highlights ways that this performance measure could be distorted,” Denes says.

Outside the research lab, meanwhile, investment professionals like Auerbach are witnessing the effects of subscription credit lines on IRRs firsthand. The Cambridge Associates consultant has met with a number of general partners who have recorded IRRs that are “impossible without the use of a commitment facility,” she notes.

“I’ll hear a number that feels high — say it’s a 2016 vintage, a three-year-old fund, and I’m like, ‘What’s the performance?’ — and they say, ‘Oh, it’s a 50 percent IRR,’” Auerbach explains. “So then I say, ‘What’s the multiple?’” If the multiple seems low in contrast to the sky-high IRR — say the value generated by the fund is only 1.15 times the amount put in — “I automatically assume there’s a commitment facility,” she says.

According to Auerbach, these kinds of lopsided performance figures started increasingly popping up five or six years ago, and have been proliferating since as managers fight to stand out in an ever-more-crowded marketplace.

“I think once GPs realized that maybe their competitors were using a little extra something-something, then they were like, ‘Well, maybe I need to use mine just a little bit too,’” she says.

General partners, for their part, are pushing back against claims that they are intentionally manipulating IRRs. Jason Mulvihill, chief operating officer and general counsel for private equity lobbying group the American Investment Council, said in a statement to II that concerns about inflated IRRs are “exaggerated and ignore the larger context in which sophisticated investors evaluate fund performance by a variety of metrics.”

In fact, an analysis by private capital data provider PitchBook found that IRRs of recent funds did not appear “categorically inflated” when compared with the IRRs of older vintages. The PitchBook analysts examined private equity funds with launch dates ranging from before 2000 to the period between 2012 and 2015, and concluded that the ratio of IRR to TVPI has stayed roughly constant across vintages, despite the increasing use of subscription credit lines.

Meanwhile, general partners and supporters like the American Investment Council have continued to point to the loan’s usefulness in bridging the gaps between capital calls. “They ensure limited partners can plan for regular capital calls, while still allowing funds to react quickly to new deals,” Mulvihill said. “This provides a win-win for the fund and the limited partners.”

Even if subscription lines of credit happen to boost internal rates of return, an artificially higher IRR is not necessarily going to be seen as negative by all, or even most, limited partners. “LPs are themselves measured in terms of IRR, and they might have their own incentives,” says Brian Gildea, head of investments at alternatives firm Hamilton Lane.

At the very least, Gildea suggests that commitment facilities have been helpful in mitigating private equity’s dreaded J-curve — the tendency of funds to have low or negative returns in the early years before investment gains start to be realized. It’s a point echoed by Adrian Sales and Tom Cawkwell, investment consultants at Albourne.

“LPs find it very difficult to say to their board, ‘Ignore the negative IRRs for a couple of years,’” say Cawkwell, who serves as Albourne’s head of private markets. “It’s a lot more comfortable to say that IRRs look good.”

The real problem with subscription lines of credit, as Cawkwell and his colleagues see it, is not their impact on IRR. Instead, it’s a lack of understanding of their use — partly due to limited disclosures from general partners.

“They’ve become a market standard,” says Sales, Albourne’s head of operational due diligence. “Our focus is more on educating clients in terms of how managers are using them, and ensuring that both the disclosure and the use of them [are] appropriate.”

Leading the effort to improve manager disclosure of subscription credit facilities is the Institutional Limited Partners Association, a trade group for private equity LPs. ILPA published its first guidelines on subscription credit lines in the summer of 2017 — a move that arguably helped usher in the current debate on the use of these loans.

The specific proposals from ILPA included recommendations on how to better benchmark manager performance and factor loans into manager hurdle rates. The guidelines also included a mandate that general partners always disclose net IRRs with and without the use of commitment facilities. According to Jennifer Choi, ILPA’s managing director of industry affairs, the limited partner group made the recommendations “knowing there would be some degree of pushback” from general partners.

“The greatest success from our perspective of that guidance is that there’s now a different conversation taking place,” Choi says. “GPs are being more forthcoming about how they use subscription lines of credit, and LPs are asking more questions and looking more critically.”

In the two years since those first guidelines were published, Choi says ILPA has continued to evaluate possible best practices for how loans and their impact on IRR should be disclosed. The investor group is loosely aiming to offer further recommendations by the end of the year.

In the meantime, another industry group, the CFA Institute, has come out with its own recommendations surrounding the impact of subscription credit lines on IRR. The 2020 Global Investment Performance Standards — an updated version of the CFA Institute’s reporting standards that’s meant to be more applicable to alternatives managers — includes a requirement that fund managers report IRRs with and without subscription credit facilities any time a loan is used for longer than 120 days.

A draft version of the 2020 GIPS, released earlier this year, had left out the exemption for loans repaid in less than 120 days. “We took a very black-and-white perspective,” says Karyn Vincent, head of global industry standards at the CFA Institute. She says they received concerned feedback from firms that “use sub lines for very short-term purposes, just to facilitate the administration of capital calls. They questioned whether it was really meaningful” to calculate IRR with and without the use of loans. Vincent believes the revised recommendation will lead to broader adoption of the GIPS standards by private equity managers.

For now, however, it remains to be seen whether the GIPS standards or the ILPA recommendations on subscription credit lines will be widely implemented by limited partners or their private equity managers. But even if the level of disclosure and the understanding of subscription credit lines start to improve, IRR’s usefulness as a performance metric has been forever compromised.

“Now you’re having to say to GPs, ‘Give me two IRR numbers, and I want the multiple,’” Cambridge’s Auerbach says. “IRR has been taken away as an acceptable first-cut litmus test of performance.”

You still can’t eat IRR — but there aren’t exactly any other performance metrics that would be easier to digest.

Multiples like TVPI, for instance, are seen as complementary to IRR, but not viable replacements. “It makes it hard to line up and compare performance side by side — particularly against other asset classes,” says Gildea of Hamilton Lane. “Other asset classes are measuring annual performance, and IRR is the closest way to do that in private markets.”

PME, which has recently started to catch on as a better way to compare private asset funds with public market benchmarks, has its own issues. Like IRR, it relies on cash flows — meaning it could also be impacted by loans. “PMEs don’t solve the sub line problem,” Sales says. “I’d say IRRs are certainly here to stay as a way of understanding the portfolio.”

For now, consulting firms like Albourne continue to advocate for the use of multiple performance metrics — and experiment with alternative ways of measuring performance. One method that is attracting some interest from clients, according to Sales, involves “running a simulation of how the whole portfolio would do with and without an investment.”

Cambridge, meanwhile, has built investment-level benchmarks, which track the performance of underlying portfolio companies rather than fund-level returns. “We’re using this to pierce the veil and look straight at the performance of underlying investments themselves,” Auerbach says.

Still, industry observers like professors Denes and Albertus are holding out hope for a replacement for IRR — preferably one that’s harder to manipulate.

“If people just quit using IRR, I personally would not be upset,” Albertus says. “And investors would probably be better off.”