(Bloomberg Opinion) — There are lies, damn lies and statistics — and then there’s internal rate of return. The internal rate of return measure used by private capital managers has long been criticized by financial and academic circles because it is easily manipulated and difficult to compare with transparent returns from stocks and bonds. Still, it exists because there’s no killer replacement.
Investors in such funds are increasingly looking to cash-based performance measures now that private equity firms have struggled to sell portfolio companies for a period due to unpredictability in the stock market and a lack of high-yield debt financing.this The numbers are not good: The largest private equity firms distributed nearly half as much cash to investors between 2012 and 2023, Bloomberg reports last week.
For the entire industry, the decline in the past two years has It’s a similar story, according to MSCI data. Its latest complete data shows global spending by private equity funds (excluding venture capital) totaling $166 billion in the first nine months of 2023. In the first nine months of 2021, the figure was $357 billion. If venture capital is included, the decline is even greater, with 2023 allocations less than one-third of 2021.
Another way to track this is to calculate capital allocations as a percentage of capital paid out to the fund each quarter. On this basis, spending growth in the first half of 2023 is expected to be similar to mid-2020, during the height of the COVID-19 pandemic. The figures for these periods are the worst since the global financial crisis of 2007-2009.
These numbers tell investors what’s going on right now, but they don’t say much about a fund’s underlying performance because of differences in investment and return timing. To combat this, investors are turning to a metric called DPI, which is the ratio of allocated capital to paid-in capital. This gives a true picture of the cash return on the money they actually hand over.
Its biggest advantage is that it can’t be manipulated – the cash in your hand is real and by definition net of fees and expenses. However, it also has weaknesses. It does not tell you about investments in the fund that have not yet been realized. In addition, dividends may be funded through portfolio company borrowings or by the funds themselves borrowing based on the value of the private equity portfolio. The second strategy has become more popular in recent quarters when selling a company has been difficult. Borrowing money either way increases the risk for the company and the fund: Long-term losses for investors can exceed short-term returns.
The IRR number claims to provide a view of how a fund is performing over time. Unfortunately, they can be very unreliable. One reason is that the timing of investments and exits matters a lot. Ludovic Phalippou, a professor of financial economics at the University of Oxford, said that if a private equity firm or individual fund achieves great success in the early stages and returns profits to investors, then almost no matter what happens, it can improve IRR in subsequent years. Saïd Business School professor and long-time critic of private equity return measurement.
In recent years, private equity firms have found ways to take advantage of this, by (guess what) using borrowed money to buy companies before asking investors for the money, or using borrowed money to repay investors before the company is sold. Either way, this shortens the time the money is actively invested and increases the apparent return in terms of IRR. Of course, the cash return will be lower because the fees and interest on the loan are paid out of profits that would otherwise go to investors.
There are other measures, such as “investment multiples,” that track the value of realized and unrealized investments but rely on fund managers’ valuation of unsold companies. Such currency multiples are also susceptible to manipulation, Phalippou said, depending on how capital circulates within the fund.
There are also many versions of another measure called “open market equivalent,” which promises to transform the simple percentage returns of indexes like the S&P 500 into better returns by aligning the schedule of cash flows with those of private equity. Something like IRR. But these are imperfect, that’s why there are different versions, and they don’t solve the problem of IRR itself.
The real answer is pain.in a frequently quoted memo Nearly 20 years ago, distressed debt investor Howard Marks wrote a book titled “You Can’t Eat IRR,” ultimately concluding that investors needed to use multiple metrics to evaluate Returns on Private Capital Fund Investments.
Even so, investors can’t be completely sure how much money they’ve made until the fund has fully repaid all capital, often more than a decade after they first invested their money. Without the ability to examine other funds in the same way, accurate comparisons are nearly impossible. Meanwhile, comparing private equity’s broad returns to public markets is little more than a pipe dream.
Former private equity manager Sebastien Canderle, who blogs for CFA Institute, concludes criticism of industry Therefore: “In private markets, no one knows your true performance.”
More views from Bloomberg:
Want more Bloomberg insights?Opinion<開始>.Or you can subscribe our daily newsletter.
To contact the author of this story:
Paul J. Davies (email protected)
