With the private equity world evolving at a rapid pace, it brings to mind one central issue: The debate centering around the proper objective/measure of investment return or GP performance.
A recent Business Week coverstory entitled “Gluttons at the Gate” (October 30th Edition) spoke judgmentally about the amount of fees charged by Private Equity funds in LBO transactions and the quick recapitalization/dividend of their investments in recent transactions.
The article did not address perhaps the most important cause of short term return focus being adopted by the private equity professionals in today’s liquid capital markets – that of the LP universe accepting a high IRR as a suitable return measure. In years past, IRR was one measure of performance but usually accompanied by a multiple of invested capital (MOIC). Some of the most recent and successful large LBO Funds have reported lofty IRR levels in their realized portfolio but have realized at less than 2X their invested capital — pointing out the short-term-return nature of their portfolio.
Individual LPs can best explain if the encroachment of hedge funds (short-term focused vehicles) into the private equity arena has influenced the acceptance of a high IRR as the appropriate objective. However, it would be foolish to ignore the presence/influence of these previously short-term focused investors in the broader alternative investment world.
Is this whole matter a “distinction without a difference” when it comes to an LP enjoying favorable returns on their invested capital? Well, this trend of high fees and large dividends/recapitalizations of investments in a short period clearly impacts the rotation/return of capital being invested by the LP community and transforms long term investment perspective into a short term investment reality. Thus the investment horizon for Private Equity funds shortens dramatically as the trend continues apace.
In a world where significant multiples of returned capital are still highly noteworthy and always impressive- has the Holy Grail of investment performance been transformed into an annual return measure? The liquid nature of capital markets permits short term riches in frothy times but the creation of sustained long term value (MOIC) will survive any illiquid market scenario.
As always, relative performance- not absolute performance- is the real measure of performance, but emphasizing a short or long term perspective can be critical in determining the Fund’s investment criteria and selection process- thereby influencing ultimate results.