Carried away

Outsized internal rates of return (IRRs) are what the private equity game is all about. According to Per Strömberg, professor of Finance at the Stockholm School of Economics, this perhaps should not be the case. 

Where leverage is being used effectively to “jack up” returns, LPs should not necessarily be happy with the result. “If you do a deal and put in less debt and finance it with more equity,” says Strömberg, “sure your IRR will be lower, but your risk is also lower. So in the risk-adjusted sense you are doing no worse.” 

Strömberg was speaking exclusively to PEI following  a roundtable debate to launch the Gimv chair in private equity at Vlerick Leuven Gent Management School in Belgium. Strömberg was joined at the debate by senior management from European private equity firm Gimv and professor Sophie Manigart, who is to hold the Gimv chair. The debate centred on the many economic benefits that private equity brings and the role the asset class will play in future.

It is fundamental principle of finance, says Strömberg, that if you lever something up, then your return on investment will increase, but the level of risk will increase proportionally. “From the investor’s point of view,” he says, “the Sharpe ratio [the excess return above an investment’s level of risk] is the same, becaues if you increase your return through leverage, then you also increase volaitiliy.”

This fundamental principle has implications on the use of carry in remunerating private equity fund managers. Carried interest is not risk adjusted. It is absolute. “If you generate an IRR of 30 percent on a deal,” says Strömberg, “you are much more likely to get carry than if you do a 15 percent IRR deal, regardless of whether it is higher risk or not.” An LP could be equally happy with a 15 percent IRR as with a 30 percent IRR, assuming the lower return is offset by lower risk. For the GP, however, “it makes a hell of a lot of difference”, says Strömberg.

Strömberg proposes, therefore, that GP compensation that does not take leverage into account gives rise to “unhealthy” incentives. “One thing we would like to see in the future – and which would be of interest to LPs – is to base GP compensation on risk-adjusted performance rather than absolute performance,” he says. 

Huge IRRs are unlikely to be a facet of funds from the vintage years of 2006 and 2007, which could produce negative IRRs to the tune of -15 percent to -20 percent, says Strömberg. These sobering figures come from an analysis of the correlation between the volume of private equity funds raised per year and the average IRRs these vintage years produce.

“When the vintage sees large volumes of private equity fundraising, then subsequent returns from that vintage are lower,” he says. The equation developed by Strömberg and Steve Kaplan, based on historic data from the US private equity market, implies that 2007, a year in which private equity fundraising was a record 1.6 percent of the value of the US stock market, will return heavy negative losses if the historical pattern continues.

“It is all based on historical data,” says Strömberg, “and maybe history won’t repeat itself. But I think people would have a hard time finding lots of evidence that it is much rosier now than in the past.”