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Editor’s Letter: The IRR controversy and reader response

We received a lot of feedback on a guest column that questioned the reliability of IRR as a measurement of fund performance. Here is a sample of the article, called “How PE funds can overstate LP returns by up to 50 pct”:

Private equity funds are the widely accepted investment strategy for pensions, endowments, family offices and other investors to access the private markets. But the reported returns of PE funds are misleading, representing only a partial view of the capital involved.

Typically, PE fund returns are shown for deployed capital, which can persuade limited partners that a fund’s returns are higher than reality — as much as 50 percent higher in fact. By carefully considering a fund investment from an LP’s perspective, we can first understand what reported returns do mean and then build a more holistic picture to appreciate the overstatement.

A response from reader Craig: Here are the problems with your analysis on GPs reporting on returns:

1. I don’t know of a single institutional LP that doesn’t calculate his or her own returns. Their reinvestment decisions are based on their own analysis.

2. Those calculations are done consistently across all asset classes and all funds within the asset class and investment decisions are made on a “relative performance” basis on an apples-to-apples comparison.

3. Of course GPs are not responsible for the return on cash distributions after distribution. All LPs assume a certain cash level based on historical experience and know that will drive down their overall return but is an inevitable result of needing liquidity for capital calls — from any asset class.

4. Your headline says the returns are overestimated. That is a misleading headline and typical of the press these days! Oftentimes the press has a balanced article but ruins it with a misleading headline. Yours should have been “There are many ways to show returns, and they can differ by 50 percent.”

The authors responded here:

Our article on PE fund returns has drawn passionate commentary because PE returns manifest differently to different LPs.

The math we illustrate excludes influences from advanced portfolio management techniques. We offer a starting framework to view fund commitments in a fundamental, “undressed” form. When the opportunity cost of committed capital is not mitigated, as we showed last week, realized fund returns can differ from published numbers by up to 50 percent.

Most institutional LPs manage fund commitments in a sophisticated manner by using commitment planning, fund diversification, serial allocation across vintage years, LP lines of credit and interim allocations to public equities. These large LPs may rationally consider that cash flow-based IRRs are appropriate, letting fund managers (fairly) defend their published numbers.

However, smaller-scale practitioners and those seeking moderate PE exposure find these practices unfeasible due to scale. To construct the minimum involvement necessary for “good” LP practices, we need to consider:

(i) Each fund will have a minimum commit;

(ii) Net flows from a fund commit need several years (at minimum one deal-lifetime) to become positive; and,

(iii) LPs desire to commit to multiple funds per year.

Consequently, we suggest a (starting point!) formula for the minimum LP allocation to PE: $AverageMinCommit * (DealYears + margin of error) * FundsPerYear = $MinAllocation

Sample values could be (at the low end): $5 million per fund * 6 years * 3 funds per year = $90mm allocated to PE. Even at a high PE allocation of 20 percent, the implied minimum AUM is ~$450 million to participate.

Alternatively, an LP could use an intermediary to aggregate PE exposures (e.g., OCIO, fund of funds, other tailored solutions). These come with an additional fee, explicit or otherwise. However it’s done, sophisticated portfolio management techniques are not free to implement.

Illuminating PE fund mechanics offers critical insight to investors considering PE investment strategies in comparison to alternative solutions, like direct investing.

Private Equity Editor Chris Witkowsky reflects at home. Photo by Wendy Witkowsky