Should private equity investors trust IRR?

But Oliver Gottschalg, professor of strategy and business policy at Paris-based HEC School of Management and head of research with Peracs, and his colleague Ludovic Phalippou, lecturer at Oxford University's SAID Business School, challenge this assessment. They have produced research that suggests IRR as a measurement tool distorts markedly to the upside when applied over a long-term investment horizon, relative to the underlying real returns of a fund.

"IRR is biased in favor of early cash flows," Gottschalg tells AVCJ. "In the first PE decade (the 1980s) returns were very impressive, although the deals were small. By the third decade (post-2000) this was much less the case, but the deals considerably bigger. This bias makes long-term IRR still look great. But it doesn't reflect reality."

The reality, according to Gottschalg and Phalippou, is that average private equity fund returns are only marginally better than those earned in the public markets.

In their study, "The Historic Performance of PE average vs. Top Quartile Returns: Taking Stock after the Crisis," the academics tracked 701 buyout firms in the US and Europe deemed sufficiently mature. Using seven years worth of cash flow (CF) and net asset value (NAV) information, they computed the net-of-fees performance of each fund and its public market equivalent (PME) benchmarks. The resultant modified IRR (MIRR) for buyout funds was 7.6% compared to 6.8% for public market investments.

The exception was top quartile funds, which delivered a MIRR of 13.6% compared to 8.5% for public market investments with the same profile.

Question marks

So what exactly is IRR and is it still a credible measure? In the simplest terms, internal rate of return is a measure for evaluating whether or not to proceed with a project or investment. If the IRR is greater than the minimum required rate of return - i.e. the cost of capital - then the logical response would be to proceed. And the higher IRR climbs above cost of capital, the greater the cash flow.

In practice, of course, it is rarely as simple as just picking the investment with the highest IRR. For example, calculations do not distinguish which target is the best strategic fit or the likeliest to hinder the competition.

"IRR is the methodology of analyzing a stream of cash flows, factoring in time to establish a rate of return," says David Fann, CEO of California-based PCG Asset Management. "In the fixed income business it equates to the yield-to-maturity; in the commercial loan business it's the effective interest rate. Business schools will tell you that it is one of the better quantitative tools in measuring and comparing various investment projects with multiple cash flows on an apples-to-apples basis."

Within this, however, there are question marks, notably concerning NAV, one of the basic elements in calculating IRR. It begins with the common, though usually fallacious, assumption that NAV equates to market value. "It's very difficult, in fact, for NAV to equal market value because nobody knows what market value is," Phalippou tells AVCJ.

The problem is rooted in NAVs underestimating cash flow. An underestimated initial NAV means too large a return, whereas an underestimated final NAV means a small return. When NAV diverges from an assumed equality with market values, the return is biased with the direction this takes. Another implication is that if early returns were high, initial NAV will be more important because the present value of the final NAV won't matter much.

Phalippou underscores that he's not saying that being conservative with NAVs equals exaggerated returns. "But more often than not, this happens; and most interestingly, it can happen in huge ways. So when you use this method, you can be way off reality above the truth," he explains. "And it's more so if you think you're being more innocent, more conservative. In fact you may be being more aggressive."

Cash flow calculations can also cause problems. It is standard practice in private equity to report performance either as an undiscounted ratio of cash proceeds over cash investments (the multiple), or as the annualized internal rate of return of all corresponding cash flows (IRR). The multiple doesn't consider the "time value of money," Gottschalg says, i.e. the fact that a fund doubled investors' money is of little value unless it is known how long the money was invested.

One important advantage of IRR is that it considers the time value of money. So the timing of the underlying cash flows has a great influence on its measurement, Gottschalg explains. There are important shortcomings in using it, though; in particular, intermediate cash flows can bias IRR results, especially for longer streams of irregular cash flows.

PCG's Fann counters that these criticisms are too harsh, observing that valuations are as much an art as a science. He adds that, under FAS157, the US accounting regulation that relates to fair value measurement, third-party auditors must review valuations of private company holdings in PE or VC fund portfolios.

"While not perfect, this imposes a standard in which the GPs need to justify and document valuations using market-standard approaches for each specific private company," Fann says. "Unfortunately, US GAAP is not universally applicable, but we find that European funds have good accounting practices. That said, it's harder to get quality information in emerging markets."

A variety of measures

Kelvin Chan, managing director of Asia private equity Asia at Partners Group, takes a view endorsed by numerous other GPs and LPs - that IRR is just one of several measures taken into account when assessing fund performance. "The return-on-cost multiple is more important to us," Chan says. "Generally, we like to avoid short-term, opportunistic investments - the kind where you get out in one year with a 100x IRR. We'd rather have 2-3x on the cost multiple, and an IRR of 20-30%."

As well as quantifiable metrics, an LP must make objective judgments based on a combination of gut feeling and past experience as much as anything else. A fund manager's track record is taken into consideration, as are the dynamics within his team and their ability to create value within a company.

In emerging Asia, where track records are thin and many GPs have been able to ride the wave of growth relatively unchallenged, the onus is on finding a fund manager who can perform across the investment cycle. The best managers make money in difficult times, identifying dislocations in the market and using them to uncover assets that don't immediately appear to have value.

Phalippou contends that MIRR, as used by Gottschalg and himself in their study, is more accurate than IRR because it adds another variable to the equation - the rate of return on the money that is invested. He believes that MIRR hasn't caught on because it requires the user to input more baseline assumptions. There are, of course, other measures: the Long-Nichols method tries to bridge the gap between private and public equity return calculations, while indexes such as the Russell 2000 are used to compare cash flows over the same time frame.

Fann, however, notes that investment analysis needs to be holistic and multi-factorial if it is to be meaningful. "Very few of us on the investment side ever take anything at face value," Fann says. "One metric by itself can easily lead to the wrong decision. It's like basing a marriage decision on shoe size."

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• Topics
• Performance
• LPs
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• Partners Group