Be-Aware of IRR Calculations in Private Equity
Don’t get us wrong, Private Equity Funds have made investors obscene amounts of money over the last three to four decades, and the lack of volatility makes it a very compelling vehicle for many investors. However like any gold rush, as competition heats up, realities start to get distorted. So its important before you invest in any Private Equity Fund you make sure the numbers they are presenting reflect the true reality of their portfolios. Below are three examples you should check for before handing over your money.
1) IRR is not the same thing as CAGR
About a year ago a private bank was trying to get the Rastogi Family office to open an account with them by pitching their private equity fund platform. They presented us with a table that showed an IRR of 16% but a Multiple on Invested Capital (MoIC) of just 2.9x over a 16 year period[1]. Looking at the IRR number I was impressed, but it somehow bothered us that the return multiple looked low, and in fact was much less than what the S&P 500 had returned during the same time on a total return basis.
It wasn’t until a few weeks later that it dawned on us, Internal Rate of Return (IRR) is not the same as Compounded Annual Growth Rate (CAGR). The key is the word “Compounded”. Had the private equity fund above compounded at that 16% the multiple returned would have been over 10x!
Let us show you what we mean. Look at the below example[2]. (Assume you invest $100 on 1/1/2002)
As you can see, on an IRR basis the PE Fund returned 16% and on a CAGR basis the S&P returned 7%. However equating the two would be a mistake, as the S&P actually returned more capital to you than the PE fund did.
We felt a bit silly not noticing this earlier, but felt a little less bad when six months later we were sitting with a successful fund manager who was telling us about his latest investment in the shares of a large publicly-listed PE fund and he said “they have done really well, a 25% IRR throughout their history” and we asked “Was it IRR or CAGR” and he said “actually I’m not sure”. It just goes to show that these terms are used interchangeably in the investment world, and you, dear investor, should be aware of this.
Now we’re not blasting the use of IRR, there is a reason it’s used in private equity returns (as cash can be returned much before the end of the fund), we just want to make sure that when you’re evaluating a private equity fund you are clear on the difference and use each metric in its appropriate manner.
2) Returns are not calculated from Day 1
When you invest in a private equity fund you have to ‘commit’ to an amount. This means that you don’t actually hand over the cash on day 1. The PE fund will ‘drawdown’ on your commitment when they have a company to invest in. The argument is that since they don’t have your money there is no return to calculate. However we find this a bit tough to swallow. While the private equity fund may be correct to say they do not have your money on day 1, you are on the hook. You can’t do much with that money that’s been committed (besides putting it in money market funds) as they can call upon it at anytime, and if you don’t have it, you’re in default. Thus, we find it much more useful to recalculate returns assuming we have given the PE fund the entire amount on Day 1.
Also it’s important to know that the timing of cash flows deeply affects IRR. The example below shows us why.
As you can see the amount of invested capital returned is the same in the two funds, however the IRRs are vastly different. PE funds have a large incentive to return large sums of money early to boost IRR numbers, but know that this does not affect the amount of money you get back.
3) Watch for IRR’s being averaged
Often you’ll find that Private Equity houses who have multiple funds like to present an ‘average’ IRR of their funds’ performance. If you take the example in point 2, the average IRR return of the two funds is ~22%. However this is not an appropriate way to establish the real return to the investor. What do we mean? See what happens when we combine the two cash flows.
When we combine the cash-flows we can see the IRR is actually more like 20%. While this might not make a huge difference to your analysis do know that averaging IRRs will not give you the most accurate picture.
In Conclusion:
None of the above in anyway implies you shouldn’t invest in private equity, and while we don’t focus too much in this space at Farrer Wealth (for a number of reasons not related to the above points), that doesn’t mean that we think it’s a poor space to allocate capital. Our only point is that when evaluating Private Equity firms, do not take their numbers for granted, ask for their cash flows and recalculate the returns yourself. That’s why the title of this post is “Be-Aware” and not “Beware”.
Happy investing all!