Investors have been pouring money into private equity for years chasing outsized returns — even though many allocators believe that widely used performance measures stink.
Institutions are questioning the real value of the internal rate of return (IRR), the most common measure of performance, according to Jos van Gisbergen, who runs private equity at Achmea Investment Management in the Netherlands. IRR measures how a portfolio performs on a dollar-weighted basis and adjusts for cash flows such as capital calls and fund distributions and is the most widely used metric by consultants and industry databases.
Van Gisbergen said private equity firms’ increasing use of subscription credit lines, even with today’s low interest rates, obscures accurate IRRs. Credit lines are used to finance transactions before funds ask for capital from their investors, which historical allowed firms to do deals more quickly but can also inflate IRR figures.
“IRR is a misleading tool to measure returns. It is a tool which is highly manipulated due to credit lines and other financial engineering tricks. It has no correlation with the risk taken,” van Gisbergen told Institutional Investor. IRR is the discount rate of all net costs and distributions. “The shorter the time period, the higher to discount rate. So it does reward GPs [general partners] for trading and not for long-term value creation,” he said.
Metrics aren’t simply an academic question, in his view. They should matter to allocators, given how much private equity has changed over the last couple decades. Using dated metrics can lull investors into dedicating too much to the asset class or create unreasonably high return expectations.
Two recent studies — one from a pair of Carnegie Mellon business school professors, one co-authored by two German researchers and a BlackRock private equity director — found that the loans have improved IRRs without increasing the actual amount of money that investors take home.
Van Gisbergen said he and other institutions are increasingly emphasizing the multiple-on-invested-capital metric to gauge fund returns. This measure is intuitive for public market investors and more readily allows comparisons between private and public equity. “If you put money into the stock market, the returns accumulate until you cash out. That’s the multiple. That is not the case with an IRR calculation,” he said. Van Gisbergen said private equity firms will provide this information if investors sign non-disclosure agreements. But he’s calling on firms for more transparency and to proactively give a range of data to potential allocators.
Credit facilities can inflate the time-weighted returns of private equity funds – the annualized return – by 300 basis points or more, according to advisory firm Triago. These credit lines are “increasingly abused, permitting managers to share in capital gains, or claim top quartile status that would not otherwise be theirs, while negatively impacting investors’ returns,” the company reported in a recent newsletter.
One U.S.-based institutional investor, who declined to be named, said, “From an institutional investor perspective, my next pet peeve is IIR. IIRs are being manipulated across the board.”
“I care about two metrics, and I teach all our analysts this: DPI (distributions we get in after we have made our investment), and total value or return on capital,” the investor said. “Those are the things that I’ll judge the opportunity set on. If it takes a little longer [to deploy capital], there may be a dilution from an IRR perspective. But total value created is what I want to see.”