Beyond IRR

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 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 fundraising, competing for the attention of an investor who is wary of taking a meeting and quick to remind you how busy they are, an eyecatching 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.

?Without the foundation of a meaningful valuation, calculation and reporting provisions are not of much value?

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 vehicle. And as Rick Hayes, senior investment officer for the 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 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 return, let alone the one that had been mooted during the fund raising. Josh Lerner, 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 all and none. Professor 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 investigation has been undertaken by Partners Group, the Swiss alternative investor that runs a number of funds of funds invested in over 100 private equity partnerships. Their analysis focussed on the limitations of IRR and looked at what credible alternatives there might be. They first pointed to the fact that one fund's cashflows can produce multiple correct IRRs and also noted the assumption embedded in the IRR concept that cashflows can be reinvested at the IRR. Next on the list of negatives was the treatment of a fund's unrealised value (see also the IRR reminder alongside this article) which makes calculation of the IRR easy, but an estimation of the final IRR all the more difficult. Finally, the volatility of the resultant IRRs left Partners Group convinced that its utility as a reliable benchmark was compromised.

To the Partners team it made sense to look for alternatives that are more reliable and which can 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. While time weighted returns track short-term performance, investment horizon returns acknowledge the long-term nature of the asset class. Partners also saw that performance can usefully be indicated by activity ratios such as investment and realisation ratios. The former is the ratio between drawdowns and outstanding commitments, the latter marks distributions against a fund's Net Asset Value. Both are illustrated in the chart on the bottom left of this page. These ratios enable an investor to gauge what Partners Group describes as ?the market's temperature? and more particularly gives an indication of the future pace of investments and exits.

Partners Group also looked more closely at the feasibility of comparing private equity performance levels originating from different investment stages and regions, using time weighted returns. The top left chart delivers a broad but telling message: that different sub asset classes within private equity occupy very different parts of the risk and return spectrum. The analysis of empirical data for the period of Q1 1988 to Q2 2002 confirms that 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 level, 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 another stand which gives you back $15,000 in the same period is preferable.?

More focus needed to benchmark
Few private equity funds are sufficiently 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-ofthumb 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, at 700 basis points, sufficiently superior, though 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).

Cumulative composite US private equityfunds formed 1989-2000Net IRR (%) to investors from 1989 to 2000

Pooled Standard Risk-adjusted Risk-
IRR deviation&#42 return score adjusted
(Sharpe score) return rank
All venture 37.1 153.9 0.19 2
Buyouts 15.3 44.6 0.18 3
Mezzanine 13.5 20.7 0.29 1
All private equity 24.6 85.2 0.20

Vintage Year Comparison for US Private Equity Funds

Vintage Pooled Pooled Pooled Pooled
Year Average Average Average Average Total
IRR Distributions Residual Value over
over Paid-in Value over Paid-in Capital
Capital [DPI] Paid-in [TVPI]
Venture 19.2 2.2 0.3 2.5
Buyout 14.7 1.7 0.2 1.9
All private 16.8 1.9 0.3 2.2
Venture 40.0 2.9 0.7 3.6
Buyout 21.2 1.3 0.6 1.9
All private 26.6 1.6 0.6 2.2
Venture 99.1
Buyout 12.8 0.5 0.9 1.4
All private 40.2 1.2 1.1 2.4

AIMR proposes more reporting detail
Here's a summary disclosure and reporting checklist of information that the US-based Association for Investment Management and Research (AIMR) is proposing should become additional provisions for private equity and venture capital funds in their Global Investment Performance Standards (GIPS). AIMR are inviting comments until 31 March 2003.

  • ? If the firm complies with any local or regional valuation guidelines;
  • ? Availability of the firm's documented valuation review procedures;
  • ? Net-of-fees and gross-of-fees annualised Since-Inception Internal Rate of Return for each year since inception;
  • ? Annualised Since-Inception Internal Rate of Return for a representative benchmark for each year since inception;
  • ? Unrealised appreciation/depreciation;
  • ? Total committed capital;
  • ? Paid-in capital and cumulative distributions to date;
  • ? Total current invested capital;
  • ? Investment Multiple and Realisation Multiple;
  • ? Ratio of paid-in capital to committed capital;
  • ? Ratio of distributed capital to paid-in capital;
  • ? Ratio of residual value to paid-in capital;
  • ? Ratio of total value to paid-in capital.
  • To see the entire proposal go to: