Why it's getting harder to trust private equity's go-to metric

The escalating popularity of a financial tool has been correlated with a rise in skewed performance figures

Why it's getting harder to trust private equity's go-to metric

The internal rate of return (IRR) is widely used across the private-equity world as a measure of how well a particular portfolio is doing on a dollar-weighted basis. While it provides a convenient index for investors to base their comparisons on, many experts and insiders say it’s a flawed metric — and it’s become even less reliable.

“[T]he accuracy of IRR has been called into question thanks to the increasing ubiquity of subscription lines of credit,” reported Institutional Investor.

Those lines of credit, otherwise known as “commitment facilities,” have allowed for transactions to be financed before investor capital is called in. Because of this, general partners have been able to jump on deals quickly without putting pressure on limited partners’ liquidity needs.

Alternatives data provider Preqin has reported an over-threefold increase in the use of commitment facilities among private-equity funds over the past decade: 13% of funds launched pre-2010 used the tool, compared with 47% of funds launched in 2010 and later. The firm has also found that such instruments, once only for short-term use, are being employed to delay capital calls for longer, which is said to lead to artificially inflated IRRs.

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The story of IRR inflation has received support from a recent simulation by two German researchers working with a BlackRock private equity director, which found that buyout funds could have lifted their IRRs by as much as 20 basis points on average had they used a commitment facility for less than six months, with larger gains seen over longer timeframes. An early draft of research by assistant finance professors at Carnegie Mellon, meanwhile, suggests that funds that had actually used subscription credit lines were able to boost their IRRs by 6.1% while causing a slight dip in the total value to paid-in multiple, or TVPI, because of the interest managers pay on the loans.

“It highlights ways that this performance measure could be distorted,” said Matthew Denes, one of the authors of the Carnegie Mellon paper titled Distorting Private Equity Performance: The Rise of Fund Debt.

Investment professionals are also testifying to the distorting effects of the instruments. Andrea Auerbach, a consultant a Cambridge Associates, told Institutional Investor she has met with a number of general partners who have logged IRRs that are “impossible without the use of a commitment facility.” She indicated that some three-year-old funds with IRRs in the neighbourhood of 50% would have multiples as low as 1.15, and that such skewed performance figures have been proliferating since they first appeared five or six years ago.

Some general partners have bristled at the suggestion that IRRs are being intentionally hacked. Analysts at Pitchbook have found that the ratio of IRR to TVPI has been relatively unchanged from before 2000 to the period between 2012 and 2015, even with the higher use of commitment facilities. Defenders of commitment facilities have also pointed to their usefulness in neutralizing the notorious J-curve trajectory of PE returns, characterized by low-to-negative returns in early years followed by an inflection to the positive later on.

Stakeholders concerned about the effects of subscription lines of credit are calling on general partners to be more forthcoming and transparent in their use. Several prominent organizations, including the Institutional Limited Partners Association (ILPA) and the CFA Institute, are reportedly coming forward with guidelines and requirements for fund managers to disclose IRRs with and without the use of commitment facilities.

“Now you’re having to say to GPs, ‘Give me two IRR numbers, and I want the multiple,” Auerbach told Institutional Investor. “IRR has been taken away as an acceptable first-cut litmus test of performance.”


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