Are Private Equity Firms Inflating Their Returns?

Worries over performance manipulation by private equity managers may be overblown, according to analysis by private-market data provider PitchBook.

In a report released Thursday, PitchBook examined whether private equity managers have used subscription credit lines to inflate their internal rates of return. These loans allow general partners to delay the date at which they call in capital from their investors – and, the argument goes, artificially boost IRR. 

As Oaktree Capital Management co-chairman Howard Marks explained in a 2017 memo, “with calls for LP capital postponed, the reported internal rate of return or IRR in the early years – the dollar-weighted return on LP capital – will increase substantially.” Limited partners, or LPs, are the investors who have committed capital to a private equity fund. 

Even after general partners start calling for investor capital, “the fund’s lifetime IRR will remain higher than it otherwise would have been,” Marks argued.

As limited partners have become more aware of the use of subscription credit lines, “the reliability of IRR has been called into question,” according to PitchBook.

“Some GPs are reportedly taking advantage of the increasing flexibility of subscription lines to intentionally and artificially boost IRRs, in some cases at the detriment to cash-on-cash returns,” the report stated.

[II Deep Dive: MIT Study Finds Private Equity Managers Exaggerate Performance]

To determine whether the IRRs of recent funds have been “categorically inflated,” PitchBook analysts examined IRRs for private equity funds across vintages ranging from pre-2000 to the period between 2012 and 2015. They then compared these return figures to cash multiples such as the ratio of the total value of the fund to the amount paid in by investors.

At first, the newer funds appeared to have inflated IRRs when compared to funds with longer lifespans. But that performance discrepancy disappeared when the analysts compared funds of similar ages by only looking at performance figures for the three-year mark of each fund.

“In aggregate, we do not find any evidence that IRR is being distorted for funds of more recent vintages,” the analysts concluded.

Still, PitchBook warned that IRR is not necessarily dependable, noting that almost half of all private equity managers end up revising their IRRs downward near the end of their fund’s life.

“IRR tends to be relatively overstated relative to cash-on-cash returns early in a fund’s life due to the mechanics of the calculation,” the firm said in the report. “We suggest that industry professionals deemphasize the importance of IRR, at least until the fund is fully invested.”