“You can’t eat IRR”.
The IRR performance bias for individual deals
We have performed these calculations at the deal-level for 5038 realised PE deals made of the past three decades in Europe and North America (excluding extreme cases – i.e. deals with a duration of less than 6 months and with an IRR of less than -50 percent or more than 200 percent – for which the IRR bias would have been even greater).
A SIMPLE COMPARISON OF IRR AND PERACS ANNUALISED RETURN
Looking at the table below, the IRR of Deal 1 (62 percent) is largely driven by the positive cash flow of 180 after only one year. According to the so-called ‘reinvestment assumption’, the standard IRR formula assumes the excess cash flow accumulated to that date (180-120=60) to be reinvested at the IRR realised to this date (i.e. 50 percent). This hypothetical investment, combined with the actual realisations in the following years pushes the overall IRR of the deal to 62 percent, despite a total return multiple of ‘only’ 1.8x over a 5 year holding period.
As our empirical analysis of actual data from 5,038 deals and 422 funds show, such performance distortions due to the use of the inappropriate IRR measure are much more frequent than one would have expected.
* See, for example, Brealey, R. and S. Myers, 2001, Principles of Corporate Finance, Sixth Edition, McGraw Hill
** See Gottschalg & Phalippou (2007), 'The Truth About Private Equity Performance', Harvard Business Review, Dec 01 2007, or Phalippou, 'The Hazards of Using IRR to Measure Performance: The Case of Private Equity'