IRR: a reminder

More and more practitioners may now be 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, not substitutes, for ?softer? criteria. But there's no getting away from the fact that IRR still matters to a lot of people a lot of the time.

Proponents will claim that when it comes to producing useful numbers, IRR is the best of a bad lot in 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,? reminds 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 openended), IRR is well suited to accommodate the kind of straightforward cashflows that occur. Some enthusiasts will also point out that its calculation is made even more straightforward ? especially when you've discovered the XIRR function in Excel that let's you incorporate daily weighted cash flows.

Others, Professor Lerner at Harvard included, question IRR's 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 of 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 leading public equity index) 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 just a retrospective assessment of the net between cash inflows and outflows. They argue that it 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 its 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 coinvested in.?