Friday Letter: A windmill worth tilting at

Net IRRs have become so inconsistent that they’re practically worthless. An SEC push for better disclosure can help with that

According to a Reuters report this week, the Securities & Exchange Commission is now focusing some serious attention on GPs’ net IRR figures. More precisely, the article suggested the regulator wanted to know whether some GPs are including the portion contributed by the investment team when calculating their net fund IRRs – because since the GP commitment isn't liable for fees, this effectively skews the net IRR upwards and makes the manager's performance look better than it actually is. Either way, the SEC also apparently wants to know whether GPs are being explicit with investors about their policy in this regard.

This news took some private equity watchers by surprise, though hopefully it shouldn't have taken the managers themselves by surprise. In September, when PEIsat down with Andrew Bowden, the man leading the SEC's presence exams, he emphasised the regulator's focus on disclosure – i.e. whether GPs are doing exactly what they said they would do. He also noted that if GPs weren't expecting any of the questions being asked during the exams, they probably hadn’t been reading their mail properly. “The letter we sent out in October 2012 … had a lot of information in it, as well as reference material attached to the letter. So, my sort of ‘smart aleck’ remark is: that if a registrant is surprised by our examination process or the questions we ask, then they haven’t been paying attention.”

Assuming this is indeed an area of focus for the SEC (it has declined to comment either way thus far), the question then becomes: is this a good use of its time, given all the other things it could be doing? On the face of it, that seems a stretch. For a start, it's hard to imagine this practice distorting returns so significantly that it would move any investor from a 'no' to a 'yes', given that the GP commitment is often in the low single digits as a percentage of the overall fund (albeit the average has been rising in recent years).

But the bigger issue here – and what ought to be behind this ‘focus’, if indeed it isn’t already – is that net IRR calculations have been something of a black box for too long. Different funds calculate it in different (usually self-serving) ways, based on their own fee structures, hurdle rates and various other factors. Everybody always seems to get a trophy when it comes to net IRR – which means that for investors trying to make apples-to-apples comparisons, even within a similar cohort, the figures GPs supply are more or less worthless as metrics.

Based on our conversations with legal and accounting sources – and what we learned from Bowden himself in September – the most likely outcome from all this is presumably that the SEC will start pushing managers to be much more explicit about how their figures are calculated. Admittedly, full disclosure from GPs on this point may just mean the insertion of a large asterisk and a paragraph explaining that investors need to consider a range of other factors beyond IRR before deciding whether to back a particular fund. Nonetheless, if these disclosures lead to more standardisation or best practice across the industry in terms of calculation methods – as you would expect it to do – that will undoubtedly be a boon for investors. And if it makes it harder for bad managers to hide behind a distorted IRR number, it’ll be a boon for the industry as a whole, too.