How a key private-equity benchmark could be hacked to inflate returns

Opaque investment structures could be hiding a financing trick that distorts returns data

How a key private-equity benchmark could be hacked to inflate returns

One of the key metrics many private-equity funds use to attract investors is the internal rate of return (IRR): the larger the return, the more lucrative a certain fund seems. But the use of a practice known as subscription-line or bridge financing could be helping certain funds inflate their IRRs.

“It works like this: As funds identify investments, they traditionally call on their investors, known as limited partners, to pony up the cash they committed to supply,” said the Wall Street Journal in a recent report. “But instead of calling that cash as soon as an asset to buy is identified, the funds borrow money to make the investment, tapping investors’ cash later.”

According to the Journal, the practice was originally used to make capital calls more predictable for LPs. But while the practice doesn’t boost a fund’s cash profits, it decreases the time during which investors’ cash is held in the fund. That shortens the apparent time needed to yield a cash profit, which could result in a significant boost in the IRR.

“[S]ome investors are growing more worried about the damage that might be done by this borrowing,” the report said. Aside from casting doubt on returns data across the industry, funds face a potential significant risk if banks withdraw their financing and certain investors are unable to deliver on their fund commitments.

“For 80% of funds, short-term use of bridge finance lifts IRRs by less than a percentage point, but for a few, the IRR goes through the roof,” said Oliver Gottschalg, head of research at Peracs, which analyses private-equity firms.

Gottschalg has analysed cash-flow data from 149 fully mature funds that began investing between 2003 and 2006. To study the potential effects of bridge financing, he recalculated their IRRs by adding in hypothetical financing on the funds’ first capital call for up to 360 days. Though most of his simulations assume only 90 days, investors say funds regularly use such financing for at least six months, with some reportedly pushing it up to 18 months.

“[M]ost private-equity firms don’t disclose this financing other than to existing investors,” the Journal said. “And while investor bodies are working to improve transparency, the industrywide returns data from consultants like Cambridge Analytics or Preqin can’t yet correct for the effects of financing.”

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