The fixed-life, distributing, non-reinvesting private equity fund is something of an oddity in the world of investment. From a purely performance measurement point of view, one of its beauties is that a fund will have no assets at the beginning of its life (i.e. prior to first draw down) and will have no assets remaining after the final distribution. And what happens between these two points is readily measurable.
WHAT IS MEASURED AND WHY
Internal Rate of Return (IRR) is the standard measure for private equity fund performance and is presented net of all costs and fees since inception (i.e. from the date of first payment to the fund by investors). The IRR is also stated net of any carried interest implied by the residual valuation. As readers of this magazine will know, this measurement has its flaws. Chief among these is that whilst the return is stated in terms of percent per annum, it does not properly reflect the distributing nature of the private equity vehicles involved. Hence a fund that has residual assets of, say, 5 percent of original commitments continues to produce an IRR based on the 95 percent of commitments that have already been realised and distributed.
In the wider world, however, measuring the performance of investments is not so simple. How many institutional investors measure their equity or bond portfolios “since inception”? Add to this the prevalence of time-weighted returns and the idea of measuring private equity against most other assets seems increasingly like trying to compare the proverbial apples and pears.
It is informative at this point to consider the BVCA Performance Measurement Survey (PMS) which in its first two years (in the mid-1990s), used only returns since a fund's inception. It soon became apparent, however, that whilst the production of collated statistics was a welcome development, they were of limited use for those who were seeking to gain an understanding of the asset class and the way it might be useful in an overall diversified portfolio of different asset classes. This was the key reason behind the BVCA's introduction of additional statistics which showed returns calculated over one, three, five and ten year periods. These statistics would show private equity returns in a similar (but still not identical) context to other asset classes and in a way that would be largely familiar to the key target audience of investors.
HOW ARE THE RETURNS CALCULATED?
In the BVCA PMS, a three year return is an IRR calculated for the three-year period. For a three-year-old fund this is clearly the same as the return since inception. To calculate the three-year return on a six-year-old fund, there is an initial draw down (a negative cash flow entry of the residual value at the end of year three) plus all of the cash flows in the three-year period plus the residual valuation at the end of year six. The resulting IRR calculation gives the three-year return.
HOW USEFUL ARE TIME HORIZON RETURNS?
The difference between measuring a return of a fund “since inception” and over, say, a three year period is directional – i.e. a return since inception measures forward from the start of a fund to a valuation date, whereas a three year return measures backwards from the valuation date to a point exactly three years prior (see Figure 1).
By way of example, Figure 2 shows the familiar IRR Jcurve for a fund that is thirteen years old and has produced an IRR of approximately 15 per cent p.a.; the IRR turns positive after about four years, whilst the return of committed capital (in cash) occurs in year 7 (Figure 3). The net multiple to investors in this fund is approximately two times committed capital including a small residual value.
In practical terms, a return since inception measures performance over the whole period that a fund was in existence, whilst a three-year return measures only the latest three-year period. This latter period might be years three to six, five to eight or ten to thirteen depending on the fund's age. In each case, however, a time-period return will largely ignore what has happened in prior years. For example, Year 3 may represent the lowest point on the J-Curve (start-up costs, early write-offs, limited revaluations etc) whilst Year 6 could be a year of major realisations after the private equity house has gone about its business of creating value. What the calculated return will not yield however, is how well the fund or, more properly, an investor's money, is performing – this can only be gleaned from the IRR since inception. Figure 3 demonstrates which periods are measured and which are not whilst Figure 4 shows the returns for the fund measured over the different time periods.
Despite the apparently high returns over even the ten-year period, the first three years (-16.4 percent) plus the last 10 years (50.3 percent) still only equate to an overall return of 15.4 percent p. a. since inception.
This is not to say that these returns are meaningless or have no value. At the most basic level, these figures can help an investor answer the question “has private equity contributed to my overall asset performance over the last x number of years?”
There is a potential danger looming though. Some fund managers – fortunately few in number – are beginning to claim top quartile performance over a three or five year period. Whilst these claims might be expected from managers of other asset classes, in private equity terms they are at best meaningless and at worst misleading.
The theoretical fund example given in this article applies equally well to the amalgamated industry statistics with the added proviso that industry statistics are usually capital weighted. In practical terms, this means that a single highly successful large LBO exit (or indeed a large failure) can have a significant effect on overall industry returns. This would not necessarily reflect an individual investor's experience – a large investor might commit 10 percent of a €500 million fund but few would be able to commit €500 million to a €5 billion fund on a regular basis.
As the private equity industry continues to mature, it is to be hoped that the industry statistics will be better understood by investors and practitioners alike. The statistics do not yet fully meet the requirements of either the investor or the manager, but as ever greater amounts of data are gathered, better and more relevant analysis and techniques will become available.
Mark Drugan is a senior investment manager at Westport Private Equity, the UK-based private equity fund of funds manager that is majority owned by alternative asset manager Man Group.