Buzz

Beyond IRR

Private Equity International


How best do you evaluate the performance of a private equity fund? Is there one right way? And does the Internal Rate of Return sit at its centre? The answers to these questions not only take you beyond that IRR but also beyond the spreadsheets and all the numbers. Private Equity International investigates how science and art meet in private equity investing.

"Just look," smiles the placement agent, "at those IRRs. These guys know how to deliver serious returns." The head of private equity investment looks at the memorandum on his desk and can't help but revisit the chart showing annualised IRRs for the private equity firm's previous funds. The numbers look impressive. And that's one reason why IRRs matter so much in private equity: a high IRR figure for your fund has been shorthand for saying that you're very good at making money. When you're out fund raising, competing for the attention of an investor who is wary of taking a meeting and quick to remind you how busy they are, an eye-catching IRR is a great attention grabber. "Sure you'll have investors telling you that IRR doesn't mean anything to them, but you still find them sniffing round the number as soon as the conversation starts," says one general partner at a UK buyout firm who regularly pitches to investors.

To declare that IRR is an empty formulation would be wrong, but to suggest that it has been significantly compromised in the eyes of many investors is not. As several of the participants in our Limited Partner Roundtable confirmed (see elsewhere in this issue), a fund's IRR is regarded with immediate suspicion and is for some little more than a starting point for their investigations when evaluating a new fund. As Rick Hayes, senior investment officer for CalPERS Alternative Investment Management programme declares: "When people say that last year the IRR on VC was 30 per cent, I don't know what that means. We have a toolkit of performance measurements: one of them is realised IRR, one is the absolute cash in / cash out and there are softer measures such as how the private equity team is adding value to the portfolio companies."

In fact, many investors will, like Hayes, use a combination of hard and soft methods when trying to get a better sense of the likelihood that this new fund - whether a firm's first or fifth - is going to deliver the kind of returns that warrant a commitment. But the decision is going to be driven by a host of factors - "it's still a mix of head and heart" says one very active UK LP - and it's unrealistic to expect any one formulation to deliver a definitive answer. And that perhaps is part of the problem with IRR: over inflated expectations as to what it signifies have prompted a number of investors to round on it (and the GPs involved) when a fund fails to deliver a suitably robust IRR, let alone the one that had been mooted during the fund raising. As Professor Josh Lerner, the Jacob H. Schiff Professor of Investment Banking at Harvard Business School says: "there's no magic bullet, but you still find people clinging to IRRs as the solution." But if you have decided to look beyond IRR for better indicators, what mathematical tools are you using instead to assess private equity?

Alternative tools

The answer seems to be both everything and nothing. Lerner recounts how a recent visit to London had him touring both leading private equity firms and investors talking to them about performance measurement: he was struck by the fact that most were reluctant - or unable - to disclose the methods they used. Others though, who see an opportunity to encourage greater debate about private equity performance (and are keen to play an active part in this), have been busy coming up with alternative analytical tools. One such is Partners Group, the Zug-based alternative investor that runs a number of funds of funds invested in over 100 private equity partnerships. Recent research undertaken by the group focussed on the limitations of IRR and looked at what credible alternatives there might be. The fact that one fund's cashflows can produce multiple correct IRRs was an immediate concern, as was the assumption embedded in the calculation that cashflows are reinvested. Next on the list of negatives was the treatment of unrealised value in a fund (see also the IRR reminder alongside this article) that made accurate and reliable calculation of the IRR all the more unlikely. Finally, the volatility of the resultant IRRs left the Partners analysts convinced that its utility as a reliable benchmark was compromised.

To the Partners team it instead made sense to look for alternatives that were more reliable and which also could accommodate the unique characteristics of private equity: time weighted returns [TWR] and Investment Horizon Return [IHR] are already embraced by firms such as private capital data gatherer Venture Economics as methods that acknowledge the long term nature of the asset class [a decade is an exceptionally long investment period] and hence the time value of money. Getting your dollars back out in year two or in year ten makes a big difference to real returns. Partners also saw that the performance of a fund could usefully be indicated by its investment ratio and realisation ratio. The former is the ratio between drawdowns and outstanding commitments and the latter marks distributions against a fund's Net Asset Value. Both are illustrated in the accompanying charts. These activity ratios enable an investor to gauge what Partners described as "the market's temperature" and more particularly also lets them assess the dependency a fund has on investments and exits.

Partners also looked more closely at the feasibility of comparing private equity performance with other asset classes using TWR and periodic IRRs. The accompanying illustrations help confirm that the variability of performance amongst different funds makes it an unnervingly different investment destination - the scattering of funds around the S&P500 index line is marked - and underlines the challenge for investors to pick successful funds. The other chart also delivers a broad but telling message: that different sub asset classes within private equity occupy very different parts of the risk and return spectrum. Unsurprisingly US venture sits way outside the mainstream, delivering a strong return but with a high risk weighting whilst European venture, strikingly, offers inferior returns but at much less risk - an indication of its markedly different character (investing in more mature and robust businesses perhaps but also being remote from the IPO boom that was part of the US tech bubble).

As one looks more closely at private equity as an asset class it becomes apparent that the aforementioned sub-asset classes manifest particular performance characteristics. At the most basic, venture funds have a fundamentally different profile to buyout funds: the amount of capital they raise and deploy, the amount of companies in their portfolio and the nature of their realisations are all factors here. This ensures that these two types of fund can manifest hugely different IRRs which in themselves might warrant commitments to venture over buyout: some US venture funds were able to report triple digit IRRs on the back of rapid fire investments and exits for instance. But as one limited partner commented: "I'm not interested in sky high IRRs generated by a quick flip or two: give me multiples. Give me a buyout fund that gives me three times the money back and I have no interest in the IRR. It's got 10 per cent instead of 110 per cent [IRR]. Who cares?" Josh Lerner at Harvard echoes the point that a stellar IRR does not mean the best capital return: "at Harvard we remind students that putting $500 into a hot dog stand that makes $2000 may give you a great IRR but the $5000 you put into the other stand which gives you back $15,000 in the same period is preferable."

More focus needed to benchmark

Most private equity funds are insufficiently diversified across an adequate range of industries to make direct comparison with mainstream indices such as the S&P 500 particularly meaningful. Instead it makes more sense to pare down a main index using sub-sector categories to produce a more closely matched indicator to a private equity fund. Given that most indices are based around standard industrial classification codes (such as the NASDAQ composite index) it seems appropriate to categorise a private equity funds investment portfolio according to those same codes. "Ideally this would be something that the private equity funds did themselves" commented one funds of funds manager. "If we could see the industry weightings of the portfolio broken down by classification we could begin to get a more accurate picture of a fund's performance.

John Buehler's recent paper for the Institute of Fiduciary Education illustrates the benefits of this more precise categorisation of a private equity portfolio. Taking the example of a VC fund that invested broadly across the technology sector, he describes how the fund was able to declare a net IRR of 60 per cent from 1995 to 1999. If this is benchmarked against the return achieved from the S&P 500 for the same period the performance looks markedly superior: the S&P delivered 34 per cent. If though the same fund was compared to returns within the technology rich NASDAQ Composite or the S&P Technology Sector sub index then the returns gap closes: the former delivered 53 per cent and the latter 52 per cent from 1995 to 1999. Given that many investors in private equity apply a broad rule-of-thumb principle that they expect to see a 500 basis point return premium from allocation to the asset class, these revised comparative benchmarks make the returns from the VC fund sufficiently superior (being 700 basis points) but not as startling as the original comparison. But there isn't really a problem here is there?

There is if you then factor in the risk premium appropriate for the sector. If the 500 bps rule applies to a mainstream index like the S&P where the risk Beta is one, then the Betas assigned to the various industries in the sub indices should be applied to sector specific funds [or for funds active in a number of sectors done on a capital weighted basis per sector). If the Beta for the technology sector is two then a risk-weighted premium an investor should expect from a private equity fund investing in that sector should be 1000 not 500 bps. Combine this revised premium with the actual returns achieved by the technology sub indices mentioned above and suddenly the VC funds IRR is inferior to both (60 per cent versus 62 or 63 per cent).

Look Sharpe

It's possible to go a step further with regard to developing risk adjusted return benchmarks for private equity by employing the Sharpe ratio which delivers the risk-adjusted return of an investment and which enables an investor to compare returns among disparate market sectors and, as illustrated in the table, among different types of private equity funds. The Sharpe Ratio uses standard deviation principles to create a risk / reward profile for an investment: the higher the Sharpe Score the more attractive the risk-adjusted return. US Venture during the period covered in the table not only was able to deliver a pooled IRR of 37.1 per cent but also a markedly higher dispersion of returns ("the good, the bad and the ugly all live in venture says one buyout-biased LP) with a standard deviation of 153.9 per cent. In terms of pooled IRR performance buyout looks disappointing at 15.3 per cent (but don't forget that multiples mark out, to take Professor Lerner's metaphor, the hot dog stalls to invest in). And the standard deviation is notably more sober too - something that novice investors will be attracted too.

Cumulative composite US private equity funds formed 1989-2000
Net IRR (%) to investors from 1989 to 2000
Pooled IRR Standard
deviation
*
Risk-adjusted
return score

(Sharpe score)
Risk-adjusted
return rank
All venture 37.1 153.9 0.19 3
Buyouts 15.3 44.6 0.18 4
Mezzanine 13.5 20.7 0.29 2
All private equity 24.6 85.2 0.20 -
*: All venture, buyouts and mezzanine standard deviation reported from inception (1989) to 1999
Source: Venture Economics Benchmark Reports, Dresdner Kleinwort Capital and EIF Group

Besides the need to have a set of competent analytical tools to work with and a number of other asset class benchmarks to reference, private equity investors endeavouring to select the best funds need to compare one with its peers. This has given rise to what the aforementioned FoF LP describes as "the cult of the vintage year." Whether this benchmarking of funds that start investing in the same year has become overplayed is open to debate, but it is certainly the case that as investors examine the track record of a particular fund they can gain a vital picture of its relative performance by comparing it with funds active at the same time in the same sectors. The most appropriate comparative funds may not be proffered by the candidate fund itself by the way. The same LP again: "as you do your homework, talk to people and pull out numbers on enough funds you begin to get a much better idea of what a fund could achieve in the right market. You'll find people coming in highlighting their IRR of 60 per cent but you then see that it's a VC fund vintage 1996 and suddenly that's way below par." As the vintage year comparison table reveals, the pooled IRR for 1996 vintage year VC was nearly 100 per cent - although most will quickly point to quick flip IPO exits and the absence of sector specific risk weighting in these numbers.

Vintage Year Comparison for US Private Equity Funds
Vintage Year Type Pooled Average
IRR
Pooled Average
Distributions over
Paid-in Capital [DPI]
Pooled Average
Residual Value over
Paid-in Capital [RVPI]
Pooled Average
Total Value over
Paid-in Capital [TVPI]
1989 Venture 19.2 2.2 0.3 2.5
Buyout 14.7 1.7 0.2 1.9
All private equity 16.8 1.9 0.3 2.2
1993 Venture 40.0 2.9 0.7 3.6
Buyout 21.2 1.3 0.6 1.9
All private equity 26.6 1.6 0.6 2.2
1996 Venture 99.1 3.7 1.9 5.6
Buyout 12.8 0.5 0.9 1.4
All private equity 40.2 1.2 1.1 2.4
Source: Venture Economics

Instead of drilling deeper into the analytical methods open to private equity investors, some perspective should be given on how significant these investors actually think any set of numbers, ratios or scores are. As Professor Lerner points out: "all the techniques in the world won't get you the clarity you hoped for: private equity investing is never going to be a purely scientific process." And limited partners will immediately acknowledge that the numbers are only part of the picture. In their 2002 survey of (real estate) private equity funds, Ernst & Young commented that "There is no doubt that there are inconsistencies in, and in many instances, a limit to, the types of information being provided to investors." The report also acknowledged that the pronounced variability in what different funds used to evidence their performance made "comparability of performance between funds during their terms based solely on traditional return measurements [are] both insufficient and impracticable."

Unsurprisingly, too many investors have seen too many varieties of numbers to make it possible for any fund to let their numbers do the talking. In this respect, moves by the Association of Investment Management and Research (AIMR) to try and establish an orthodoxy to performance reporting can be seen as trying to re-establish some credibility. As the Association says in its summary to the proposed venture capital and private equity provisions: "These principles are meant to bring consistency and transparency to the valuation methodologies used. Without the foundation of a meaningful valuation, the various calculation and reporting provisions are not of much value."

Interestingly a survey currently being undertaken of European LPs by a European placement agent has preliminary results showing that the numbers are ranked as the most important factor when evaluating a new fund. More admittedly anecdotal evidence when interviewing US LPs would suggest that significance of the numbers for these investors would rank below both the people involved and the proposition or strategy of the fund. Whether this indicates a healthy scepticism on the part of the US buyside born of experience with the numbers may be debatable but every investor will agree that the non-mathematical, non-quant, non-scientific factors are vital when formulating that investment decision. Says the FoF LP who is busy investing his latest fund across a range of funds from all sub asset classes of private equity: "I ignore the numbers. I read the bios of the guys, look at the plan then, and only then, maybe flick through the claims they're making for their past performance. Do I rely on these? Never. Will I through them back at the guys when I meet them? You bet."

IRR: a reminder

Even if some are now recommending that a fund's Internal Rate of Return should only be one of a set of analytical tools used to evaluate private equity performance, and that these tools as a group are complements, and never substitutes, for "softer" criteria, there's no getting away from the fact that IRR matters to a lot of people a lot of the time.

Proponents will claim that it is the best of a bad lot when it comes to producing useful numbers from that analytical toolbox, as it is capable of reflecting the diversity of cashflows into and out of a private equity fund. In comparison, for example, calculating Time Weighted Returns (TWR) removes the impact of these cashflows.

And because the GP controls the cashflows into and out of the fund it is important to use a tool such as IRR that recognises the effect of these flows - and hence factors in the time value of money. "The decision to raise money, take money in the form of capital calls and distribute proceeds is totally at the discretion of the private equity manager. Thus timing is part of the investment decision process and thus the manager should be rewarded or penalised by those timing decisions," remionds AIMR in its reporting recommendations proposal for private equity firms.

This also happens to serve as a good reminder as to why some GPs will spend significant amounts of time mapping out cashflow schedules that optimise IRR. Just ask a lawyer who has spent considerable time on behalf of his limited partner clients negotiating revisions to the compensation clauses in a fund document where the fund's IRR was critical to determining who got how much. "It's amazing how the distribution of hundreds of millions of dollars helps focus people's minds."

Here's a definition: IRR is the discount rate that would result in a Net Present Value (NPV) of zero for a series of discounted inflows and outflows and can be represented by the following equation:

N is the number of periods, c is the compounding factor (so 4 for quarterly and 2 for semi-annual) and r is the discount rate. Distributions are the cashflows out of the fund (back to the LP) and contributions are the cashflows into the fund (capital calls) made during the nominated period.

IRR proponents, and in this regard this includes the AIMR, will also remind you that because the typical private equity fund is a fixed life, closed fund with a set total amount of capital (in other words, is neither evergreen nor open-ended), then IRR is well suited to accommodate the kind of cashflows that occur. In their estimation, because of the straightforward nature of the cashflows and the closed-end basis of the fund, there are few scenarios that will beat IRR. Some will also add that its calculation is made even more straightforward - as soon as anyone discovers the XIRR function in Excel that lets you incorporate daily weighted cash flows.

Others, Professor Lerner at Harvard included, question IRRs reliability and simplicity. Not because it is intrinsically flawed but rather because it can be manipulated and also because it can give more than one mathematically correct answer. Says Lerner: "One of the biggest problems is what in academic terms you could call multiple roots: that a single set of cash flows can produce multiple IRRs. This happens where there are cash flows that go in and come back, then go in again then come back. For instance a fund draws down some capital, had a quick hit with an IPO and distributes the shares to LPs, then draws down a second and third tranche of capital. There you have a situation where a calculation can produce two or three IRRs each of which is a right answer." And it's worth noting too that the Excel spreadsheet you've used will not alert you to the alternative IRRs that are computable, adding further to the likelihood for confusion. What about manipulation? Professor Lerner prefers to call it "gaming" but the principle is the same: by engineering the cash flows you can produce a startlingly high IRR. One tactic is to use a "time zero" approach where instead of taking in cash flows as they occur, people instead aggregate them as if they all occurred on day one.

Fans of IRR at this point may simply shrug and tell you not to blame the tool when you should be blaming those who abuse it. Others will suggest you use Modified IRR. Given that the uneven and variable nature of the cash flows into and out of a private equity fund can create multiple correct but different versions of its IRR, some suggest that this, a "purer" version of IRR, is preferable. To calculate Modified IRR you assume that a single contribution (capital call) is made to the fund at the first date of calculation instead of multiple contributions over time. To reach this figure, each contribution is given a present value for the date of calculation by discounting it by an appropriate benchmark [such as the Treasury Bill rate].

Some modify the equation further by also applying this principle to the distributions out of the fund as well: again, the aim is to establish a single figure [in this case the distribution value at a particular close date] to feed into the IRR calculation. To achieve this, you again have to apply a specified rate of an appropriate comparative (such as a public equity index like the S&P 500) so that the cash flows coming out of the fund earn money according to a specified schedule from the day of distribution until the effective date of the IRR. This is achieved by compounding each distribution by that specified comparative rate to a future value at the effective date. The result, in the end, is a very simple IRR calculation, using one cash flow in and one cash flow out.

Now's a good time to introduce another fundamental issue that makes a fund's IRR open to question and this relates to the valuation of the unrealised portion of the fund. Although the cashflows out of a fund can be given a hard value (some will be cash, others will be stock and these latter outputs can be open to varied valuation as the chart in the main feature illustrates), the unrealised portion of the fund has to be ascribed a valuation too and this is far more subjective. In this regard critics of IRR argue that as a measure of portfolio performance it is a just a retrospective assessment of the net between cash inflows and outflows. It, they argue, completely ignores residual value and is therefore incomplete unless the fund has been liquidated or is near liquidation - when the unrealised value of the fund has become insignificant.

Many, GPs included, will acknowledge that the valuation of the unrealised portion of a fund is difficult - or in other words open to debate. In an effort to try and bring some sort of consistency to the valuation process both the EVCA and the BVCA have released guidelines for its members suggesting valuation methodologies to employ - but these are no more than guidelines and it remains very much up to the particular GP to decide how they want to value their portfolio. One important factor here is the extent to which a fund's advisory committee is able to review and approve all asset valuations for the fund. This is where a fund's existing limited partners can gain a clear picture of that unrealised portion of the portfolio and a growing number are asking for information at the portfolio company level, including quarterly summary financials for each company and a report from the GP assessing whether the investment is tracking on, below or above targeted IRR. This though is not something that readily reaches prospective investors in a fund and it is down to the new investor in their due diligence to examine the make up and valuation of the unrealised portion of a firm's previous funds to gain a more accurate picture of it's real potential.

A continuing issue since the upheavals of 2000 is the extent to which private equity firms have written down the value of their portfolio companies in the wake of the profound devaluations of publicly traded companies operating in the same sectors: technology in particular. Some are still holding these investments at the valuation determined when they first invested, others have trimmed the valuation to match the latest round of financing, whilst a (very) few have taken it on the chin and written off some of their portfolio entirely. UK listed private equity group 3i is a case in point here: their prompt writing off of portions of their technology portfolio had other venture capital firms who were invested in the same companies alongside 3i blanching at the prospect of having to do the same. As a director at one such firm said: "I knew those guys had upset the apple cart as soon as I started to get calls from my limiteds quizzing me about the companies we were co-invested in."