There are lies, damned lies and statistics – and then there’s IRR. The internal rate of return metric used by private-capital managers has long had critics in finance and academia because it is easily manipulated and hard to compare with the transparent returns of, say, stocks and bonds. Still, it survives because there is no killer alternative.
Now, after a spell when private equity has struggled to sell portfolio companies due to unpredictable stock markets and a lack of high-yield debt funding, investors in such funds are increasingly looking at cash-based measures of performance. The numbers aren’t great: Cash distributions by the biggest private equity firms to their investors dropped by almost half between 2012 and 2023, Bloomberg News reported last week.
For the whole industry, the picture of decline over the past two years is similar, according to data from MSCI. For the first nine months of 2023, its most recent complete data, total payouts from global private equity funds, excluding venture capital, were $166 billion. In the first nine months of 2021, that number was $357 billion. Include venture capital and the drop is even greater with 2023 distributions less than one-third of those in 2021.
Another way of tracking this is to calculate capital distributions as a percentage of capital paid in to funds in each quarter. On that basis, the first half of 2023 saw payouts running at a similar rate as mid-2020, the depths of the Covid pandemic. Those periods saw the worst numbers since the global financial crisis of 2007-2009.
These numbers tell investors what’s happening right now, but they don’t say much about underlying fund performance because of differences in the timing of when money is invested and returned. To address that, investors are turning to a measure known as DPI, the ratio of distributed to paid-in capital. This gives a real picture of cash returns on the money they actually handed over.
The great strength of this is that it can’t be manipulated – cash in your hand is real and by definition comes after fees and expenses. However, it too has weaknesses. It tells you nothing about unrealized investments still in a fund. Also, dividends can be funded by borrowing either by portfolio companies or by the fund itself against the value of a private equity portfolio. This second tactic has become much more popular in recent quarters when selling companies has been tough. Borrowing in either way can increase risks for companies and funds: Investors could lose more in the long term than they get paid in the short term.
IRR numbers claim to offer a view of how a fund is performing through time. Unfortunately, they can be deeply unreliable. One reason is that the timing of investments and exits has a big influence. If a private equity firm or an individual fund has big wins in its early years and returns the proceeds to investors, that can boost the IRR for years afterward, almost no matter what happens, according to Ludovic Phalippou, professor of financial economics at Oxford University’s Saïd Business School and long-time critic of private equity return measurement.
Private equity firms have found ways to exploit this in recent years by (guess what) using borrowed money to buy companies before calling down capital from investors, or by using borrowings to pay investors back before a company is sold. Either way, this shortens the time that money is actively invested and boosts the apparent return in IRR terms. Of course, the cash return would be lower because fees and interest on loans are paid out of profits that otherwise would go to investors.
There are other measures, too, such as “multiple of money invested,” which can track the value of realized and unrealized investments, but which relies on fund managers’ valuation of unsold companies. This money multiple is also open to manipulation, according to Phalippou, depending on how capital is recycled within a fund.
There are also many versions of another measure called a “public markets equivalent,” which promises to convert the simple percentage returns of an index like the S&P 500 Index into something more like an IRR by aligning the timing of cashflows with a private fund. But these are imperfect, which is why there are different versions, and they don’t address the problems with IRR itself.
The real answer is painful. In a much-quoted memo from nearly 20 years ago, entitled “You Can’t Eat IRR”, the distressed debt investor Howard Marks ultimately concluded that investors need to employ several metrics to assess their returns on private capital fund investments.
Even then, investors can’t be completely sure what they’ve made until a fund has fully repaid all capital – often more than a decade after they first committed money. And without being able to examine other funds in the same way, accurate comparison is almost impossible. Meanwhile, comparing broad private-equity returns to public markets is little more than a pipedream.
Sebastien Canderle, a former private equity manager who writes a blog for the CFA Institute, concluded a critique of the sector thus: “In private markets, no one can figure out your true performance.”
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