Just how bad is IRR?

“You can’t eat IRR”.

Many PE investors have read or heard this phrase somewhere. And as will be demonstrated below, internal rate of return (IRR) truly is a terrible measure of PE performance. Our results provide compelling arguments to come up with something much better urgently.

Fundamentally, this insight is not new.  Leading MBA finance textbooks dedicate entire chapters to the shortcomings of the IRR measure in general*, while academics specialising in PE performance measurement have made powerful arguments warning investors about the possible biases in any IRR-based performance assessment**. The most dangerous bias in IRR is related to the fact that the IRR calculations give too much weight to returns generated early over the life of a fund or investment, as early net proceeds are assumed to be reinvested at the rate of return generated until that point in time. Still, investors continue to rely on this performance measure.

So why they are doing so? One reason may be that we know (in theory) that IRR can be biased, but until now, there has been little evidence as to how substantial this bias really is. In this study, PERACS and HEC Paris provide such evidence – and the results are somewhat frightening.

In collaboration with several leading LPs, including Munich-based Golding Capital Partners, the PE Observatory at HEC Paris has assembled a unique set of data on the detailed PE performance for over 5000 realised investments made by 422 private equity funds.  We have been able to leverage this rich data source to assess the magnitude of the IRR bias across a large and diversified sample of investments and funds.

Based on the analysis of the exact timing and amount of cash flows for each of these deals, we have been able to compare results from the standard IRR method to those of a simple but vastly superior performance measure, the PERACS Annualised Rate of Return (see box on p. 38 for details), which is calculated based on an investment’s total return multiple and its duration. This performance measure captures directly how much value has been generated over what period in time, without any need for assumptions regarding reinvestment rates.

 
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).

These deals had an average IRR of 32 percent (median 28 percent) and an average total return multiple of 3.4x (median 2.3x). The average duration of these deals was 3.9 (median 3.5) years (N.B. 50 percent of our deals had a duration of more than 5 years or less than 2.3 years, which illustrates why it is not an option to simply use the return multiple alone as performance indicator; after all, it makes a huge difference if one ‘doubles one’s money’ in two or five years).

Drawn from a sample of realised investments made by established PE houses, these average performance values are not representative for the entire industry and indicate an upward biased sample. However, this data is perfectly suitable to assess the magnitude of distortions attributable to the IRR method.

Comparing IRR and PERACS’ Annualised Rate of Return for the 5038 deals, we find that in 12.8 percent of this sample, the IRR measure deviates by more than 10 percent (in relative terms) from the more accurate PERACS Annualised Rate of Return measure. This implies that whenever you see a quoted deal IRR of, say, 30 percent, there is a one in eight chance that the real performance (based on the PERACS Annualised Rate of Return) is greater than 33 percent or less than 27 percent. Not exactly a negligible problem.

For 3.7 percent of the deal sample (still 186 real-world investments), the distortion even exceeds  one-quarter of the stated IRR – so if one of these deals has a 20 percent IRR, its actual performance was below 15 percent or above 25 percent.

It is also interesting to observe that the IRR bias can go either way: IRR may be above or below our Annualised Rate of Return. However, we find that given the typical cash flow patterns in PE, it is much more common to find an upward bias. For 75 percent of the  645 deals with an IRR bias of greater than 10 percent, this bias was upward, creating an average upward bias of these 645 deals of +12 percent (in relative terms) over their actual performance as measured by our Annualised Rate of Return.


The IRR performance bias for private equity funds

IRR is widely used as a fund-level performance measure in private equity. As the streams of cash flows for PE funds are generally longer and more irregular than for those of single investments, one would expect the distortions of the IRR performance measure to be even greater at the fund level. To verify this expectation empirically, we analysed fund-level cash flows for 422 PE funds in our database. All these funds have made at least 10 (realised or unrealised) investments and we consider the final net asset values for the unrealised deals as a final cash flow.

Replicating the approach above, i.e. calculating both the standard IRR and the PERACS Annualised Rate of Return for these 422 funds, we find indeed that the use of IRR as a performance measure is even more problematic at the fund level. We observe that for over 30 percent of the funds, IRR deviates from the PERACS Annualised Rate of Return by more than 10 percent (in relative terms). For 44 funds (just over 10 percent of our sample), this distortion exceeds even 50 percent!  In other words, if a fund reports a 25 percent IRR, then there is a 30 percent chance that its actual performance as captured by the PERACS Annualised Rate of Return is below 22.5 percent or above 27.5 percent …  and with a 10 percent probability it will be below 15 percent or above 45 percent.

One can easily imagine how such difference may wrongly put a fund in a given performance quartile relative to its peers. The danger lies in the fact that these biases occur almost at random, largely driven by the cash flows that occur early in the life or a fund (or deal). If a fund’s performance turns out to be misrepresented by the IRR measure, the fund managers can hardly be blamed; in many cases they may not even be aware of it, and after all they only apply the most standard performance measure of the PE industry, incorrectly assuming that this would lead to a correct apples-to-apples comparison.

But given the findings from our study, it may be high time to change this standard! 


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.

One would expect an IRR of 62 percent over 5 years to generate a multiple of (1+0.62)^5=11.1x! Clearly, the capital was not fully invested over 5 years. The deal’s duration, i.e. the difference between the capital weighted average date of all realisations and the capital weighted average date of all investments, is only 1.38 years for deal 1. But even if we consider the duration instead of the simple holding period, the IRR returns still do not match as (1+0.62)^1.38=1.94x, which is different from the multiple of 1.8x.

The simple but powerful solution is to ignore the IRR measure altogether, as it is simply unsuitable for PE type cash flows, and to calculate the PERACS Annualised Rate of Return based on multiple of investment and duration as follows: PERACS Annualised Rate of Return = (Multiple x (1/Duration in years)) – 1

This PERACS Annualised Rate of Return, 53 percent in our case, is an unbiased and accurate measure of performance at the deal-level. We see that Deal 1 has an upward biased IRR of 9 percent in absolute terms, i.e. 17 percent relative to the Annualised Rate of Return of 53 percent. If we combine the two deals in this example, the difference between IRR (51 percent) and PERACS Annualised Rate of Return (37 percent) becomes even larger, as the 14 percent difference in absolute terms corresponds to over one-third of the PERACS Annualised Rate of Return.

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. 

Footnotes:
* 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