Performance anxiety: the quest for better benchmarks

…Could relative performance measures ease some of the pain – and help LPs make better asset allocation decisions? Amanda Janis reports

Private equity investors have been complaining about IRRs for over a decade. 

“You can’t eat IRRs,” was one of the first – and most memorable – such limited partner quotes Private Equity International ever reported. That came from Sandra Robertson – now CIO of the Oxford University endowment and then an investor for Wellcome Trust – during the 2001 EVCA annual meeting. 



If you go to the grocery store, what do they want – cash or IRR? 

Réal Desrochers 


Another favourite: “I always say to the board: If you go to the grocery store, what do they want – cash or IRR?” That was Réal Desrochers – then the private equity head for CalSTRS and now for CalPERS – speaking to PEI back in 2007.

The chorus of voices in favour of cash-on-cash or other absolute return measures like time-weighted returns (TWR) has grown louder over the years. Some of investors’ main gripes have been that IRRs are subject to valuation bias, and that different timing of cash flows can distort returns. So too can the sequencing of investments, with large wins or losses early on greatly impacting a fund’s IRR. As one investor put it, managers “know how to work their IRR”.

WHEN IS A 2x NOT A 2x?
Despite this, most LPs will still want to look at IRRs as well as multiples. “I always say you need both,” says Christian Diller, partner and co-founder at Montana Capital Partners. “IRR is a measure that says something about how long it takes to get your money back; the multiple gives an idea of how much it is.”

To illustrate his point, Diller explains that an investment returning 2x in 2006 or 2007 may have had a big IRR, but an investment returning 2x today would probably have a much lower IRR. “Right now it takes a little bit longer [to exit] and because of that IRRs are much lower than investments exited in 2006-2007.”

Investors also use both measures to benchmark performance against similar funds tracked by a number of commercial databases including Thomson One (formerly Venture Economics) and Cambridge Associates. 

“You definitely want to track how your fund is doing relative to other similar funds; that’s what people do with IRR and multiple of invested capital,” says Steven Kaplan, a scholar who works often on private equity performance issues. Kaplan, who is the Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at University of Chicago Booth School of Business, says choosing the right database provider to create a benchmark is key, however – because each data set has its own limitations.

Montana’s Diller agrees. “It’s good to use these indices as a benchmark or also to derive performance numbers for private equity. On the other hand, I would also certainly look at the composition of these indices because if you are a European investor, for example, a lot of these indices might not reflect what you have in your portfolio.”

Jenny Fenton, Altius Associates’ co-founder and COO, adds: “There’s a number of different indices these days and they all have their flaws. In addition to industry benchmarks, a lot of clients also have an internal benchmark, which is typically some sort of public market equivalent.”