Numbers that lie: IRR, fee offsets, deal attribution and loss ratios

In the final part of our series on private equity metrics, PEI examines why the internal rate of return can flatter to deceive.

An illustration of a cut-out dice

IRR | Tricky but sticky

You famously can’t eat it, it is derided by many, yet IRR – internal rate of return – is still used by nearly everyone. And it is not going away anytime soon. “It’s the best metric we have for evaluating private equity and benchmarks relative to other asset classes,” Hamilton Lane’s head of investments Brian Gildea says. “Unfortunately, it’s not perfect.”

Whether you consider it to be manipulative or not, there are two ways in which a headline IRR can prove a false friend. Number one is the use of credit facilities.

A September study by Montana Capital Partners’ Christoph Jäckel on a sample of 491 funds concluded that use of a credit line can substantially improve a fund’s IRR by a mean of 4 percentage points. The better a fund performs, the bigger the impact of the credit facility on IRR.

Jäckel’s study added to a growing body of research into the effect that delaying capital calls from investors is having on IRR. A June report from Carnegie Mellon’s Tepper School of Business found that the lines distorted a fund’s IRR by 6.1 percentage points on average.

Investors are now wise to the impact of credit facilities. In line with guidance issued by the ILPA, many are now asking for GPs to report their IRRs twice: once with the effect of the credit line and once without.

“I spoke to one GP recently that said credit lines have improved their performance by up to 3 percent,” says Torben Vangstrup, managing partner of ATP Private Equity Partners, the fund of funds arm of Denmark’s largest pension. “We need to be able to compare all GPs on equal terms, so we have to actually adjust for the use of credit lines in the performance data. Every due diligence we do going forward, we’ll ask the GP to make that calculation for us.”

The second way IRR can flatter to deceive is the effect of an early win. If the first deal to be realised is a roaring success in terms of IRR, then the whole fund benefits from the “re-investment assumption” for the life of the fund. In other words, if two funds were to do an identical set of deals, just in a different order, they would emerge with different IRRs.

Another way in which net IRR can be obscured is if a non-fee-paying co-investment pot or the GP commitment is included in the net IRR figures. The fee-free component will push up the net IRR.

The answer for investors is to access cashflow data and recalculate using their own methodology.


FEE OFFSETS | Check legal small print

Limited partners can take comfort these days that having agreed to a management fee, this will not be supplemented with an array of other chargeable services from the general partner.

Per ILPA’s latest guidelines, any portfolio company fees that are charged should be 100 percent offset against the management fee.

“Fees exempt from the offset provisions should be rare, but clearly defined in the LPA,” read the guidelines. “Where such fees are not fully offset, the GP should disclose the amount of fees received by the GP, including those that fall outside of any offset provision.”

“Excluded fees can be material – sometimes up to 30 percent more,” says Eamon Devlin, a partner at MJ Hudson. “The transparency that LPs receive around portfolio company fees isn’t always very good and it’s usually presented after the fact. One way to solve this would be for GPs to disclose to LPs all of their direct and indirect fee income received and where it came from.”



There is a reason that some long-time limited partners keep their own records of which individuals among their GPs lead each deal. It is to ensure that, in the event of a key departure, that track record does not get quietly reassigned to someone else who has stayed at the firm.


LOSS RATIOS | Define please

In its 2019 survey of managers and investors, eVestment found that loss ratios are a significant part of investor due diligence: 68 percent of investors described the metric as being either “extremely” or “very” important. But definitions vary. For some, a loss ratio of 10 percent means that one in 10 deals lost money. For others, it means that 10 percent of the fund’s capital was lost.