Inside IRR

Say ?IRR? to anyone involved in private equity and venture capital investing and you can be guaranteed to get an animated response. The Internal Rate of Return has become the most widely used performance indicator for private equity and venture capital funds and along the way has picked up both ardent fans and critics. The fact that the fans tend to originate from within the private equity industry and the critics from the investing community makes the debate all the more pertinent. It seems that parties on both sides continue to regard each other with suspicion and regard their diverging attitudes to the interpretation and application of IRR as telling justification as to why they are on their guard.

With investors rejecting it as a figure all to easy to engineer to flatter performance and private equity firms continuing to use it as a badge of honour, the argument over IRR is set to continue. Or in fact escalate: as one Swiss fund of funds investor commented, ?private equity firms have got to wake up to the fact that IRR is not an adequate performance indicator and that we are not going to buy into their fund simply because they claim a top quartile IRR ranking ? everyone always says they're top quartile.? Or as Sandra Robertson, who invests in private equity for the Wellcome Trust, said at the EVCA's annual meeting last year: ?You can't eat IRRs.? Instead, it's the distributions of cash and stock that funds make to their LPs that interest prospective investors.

A vivid example of how seriously IRR is taken ? and why it is prone to misinterpretation ? came during last year's furor over CalPERS' posting on its website the IRR figures of the private equity funds it is invested in. The Financial Times picked up the story and published an article on July 18 leading on private equity firms' reluctance to publicly disclose detailed performance information and predicting that the private equity funds referenced in CalPERS' report would ? bar the top rankers perhaps ? be less than happy at the details revealed.

At least one of the funds was indeed bemused ? especially about the article. US buyout firm Hicks, Muse, Tate & First was irked as the piece suggested that its Fund III was shown to have an overall IRR of only 5 per cent. In a memo sent to the Financial Times on July 19 (as well as to the LPs invested in Fund III), partner Dan Blanks upbraided the paper's journalist for misinterpreting the data: in particular for failing to avoid falling ?into the many traps that can lead to inaccurate or invalid conclusions.? Blanks explained that CalPERS' late arrival as an investor in Fund III meant that it had missed out on a number of early distributions and hence saw an IRR of ?roughly 5 per cent?, whereas inclusion of all of the LPs in the fund (especially those who had committed capital earlier than CalPERS) generated an IRR of 14.4 per cent for the same time period. Besides Hicks Muse's evident dismay at having one of its funds tarnished with a paltry IRR figure, what reading the company's memo also reaffirms is the point that trying to fix an IRR for a private equity fund can be like trying to nail jelly to the wall.

So what is this IRR thing?
IRR measures interim cash-on-cash return earned by investors from a fund's activity from inception to a stated date. It can be defined as the discount rate that would result in a net present value (NPV) of zero for a series of discounted inflows and outflows and can be represented by the following equation:

Here, N is the number of periods, c is the compounding factor (4 for quarterly, 2 for semi-annually) and r is the discount rate. Distributions and contributions refer to the cash flows out of and into to the fund during the appropriate period (and in the last fiscal period distributions should include any net assets of the partnership).

And already one is running into trouble: the timing of these cash flows can significantly distort a fund's IRR (see the boxed item elaborating this point on page 31). Talking to Josh Lerner, Jacob H. Schiff Professor of Investment Banking at Harvard Business School and a noted authority on private equity as an asset class, it's clear that different people will use a different chronology for these cash flows ? at times for what Professor Lerner dubs as ?gaming.? Says Lerner: ?When you look at how people report performance there's often a lot of gaming taking place in terms of how they manipulate the IRR. For instance, there's the ?time zero? method where instead of looking at the cash flows as they occur, people in many cases just aggregate naked as if all of the cash flows happened on day one. Although that sounds like an innocuous change this will often have a dramatic impact on the IRR that is actually reported.? This can sound to many investors all too much like a fund is artificially inflating its IRR and is a key reason why IRR has become discredited.

?IRR is not an adequate performance indicator?

But even if you do everything right ? that is, in a textbook manner ? the IRR itself still has severe problems. Although IRR can cope with symmetrical cash flows in and out (and the larger the number of these, the greater the smoothing out that occurs), as soon as these start to be variable, the cracks begin to show in its computation. And it's safe to assume that virtually every private equity fund will have asymmetrical cash flows both in terms of value and timing. This complexity helps create a situation where differing interpretations of cash flow timing come into conflict with each other (for instance, at what point did the fund pay out stock to its LPs after an investee company IPO ? and if there's a lock up on these and the price then slumps what are they worth?). As Professor Lerner says: ?One of the biggest problems is what in academic terms you could call multiple roots: that a single set of cash flows can produce multiple IRRs. This happens where there are cash flows that go in and come back, then go in again then come back. For instance a fund draws down some capital, has a quick hit with an IPO and distributes the shares to LPs, then draws down a second and third tranche of capital. There you have a situation where a calculation can produce two or three IRRs each of which is a right answer ? and this can be tremendously confusing.?

Watch out for valuations
If one looks beyond the issue of contribution and distribution timing, then another critical area of debate within IRR appears: the valuation of as yet unrealised assets within the fund. Again, different parties will take different views as to the valuation of a holding in a company (be it private or public). Often, the method of determining this in order to calculate an IRR is to set an end of period value using the general partner's valuation and adjusting for any cash flows that occurred between the general partner's valuation date and the valuation period being reported. And as the University of Texas Investment Management Company puts it when explaining its calculation of investment returns for its alternative equities ? nonmarketable programme: ?Valuation for other nonpublicly traded investments held by this asset class is based on the latest significant round of financing at which a price was established by a material third-party participant. Publicly traded restricted stocks and bonds held by this asset class are discounted 20 per cent for illiquidity. In unusual circumstances a valuation adjustment will be made for a significant event not reflected by the valuation method used. If no ascertainable value is available for an investment, book value of the investment is used for the investment's market value.?

The question is whether the private equity fund is prepared to accept a valuation determined by a funding round that may seem remote from the subsequent performance of the investee company and the valuation reference points that the public markets provide for companies in the sector. The most stark examples of how the interpretation of performance and public market valuation benchmarks can distort valuations came during the Internet stock boom where start-up and early stage investments were made by VC and private equity firms into companies that seemed ripe to push to IPO as quickly as possible. Many funds were able to push a number of their investee companies into the public markets during the boom and were able to deliver startling returns to their LPs. IRRs went through the roof and, for many, it is the aftermath of these heady days of the late nineties that has made IRR a dirty word. As one UK GP says: ?Those were crazy times. You had people expecting ? and, more terrifying still, promising – triple digit IRRs.?

?People were expecting ? and, more frighteningly still, promising ? triple digit IRRs.?

Then the rot set in and stock market prices for Internet companies big, let alone small, fell apart. First, GPs who had companies hitting the markets had to watch as their launch prices crumbled (and don't forget that aforementioned lock up period: that £10 issue price soon slumped to £0.50 and the distributions to LPs suddenly looked very slim). Second, portfolio companies still remote from IPO suddenly looked far less valuable than before. What were these worth now? And what might they be worth as and when an exit materialised? As Dan Blanks of Hicks Muse (under)states in his note to the Financial Times: ?In contrast to public equities, for example, private equity funds, being illiquid, cannot be accurately valued on an interim basis.?

So who likes IRR?
Many though are still prepared to accept IRR as the best indicator to use when assessing private equity funds. As Professor Lerner confirms, many investors are looking for a hard number to use when evaluating a fund: IRR works for other asset classes so why not for private equity? Thus IRR remains the recommended performance measurement amongst many institutional investors for the presentation of investments in private equity and is cited by the US Association for Investment Management and Research in its AIMR Performance Presentation Standards Handbook as such.

The private equity industry itself also continues to use IRR as a performance benchmark. Research group Venture Economics has worked long and hard to garner information from the private equity and venture capital industry and now tracks 1400 US funds, 515 European and UK funds and 175 other international funds. The group has also endeavoured to move beyond the simple IRR methodology though, in an effort to deliver useful comparative information: cash on cash fund returns, cumulative IRR, the use of vintage years (the year of a fund's inception), time-weighted returns, investment horizon returns and public equity comparables are all part of the information tool kit that it now provides.

Venture Economics continues to use IRR as an integral part of its analysis of industry performance. As the chart, on the next page, showing European Private Equity Five Year Rolling IRRs reveals, the data generated can still provide valuable trend indications. The analysis for Europe, produced annually in association with the EVCA, last year tracked a total of €69.8bn of committed capital in 479 funds (of which 427 were mature, i.e. formed between 1980 and 1998). It leads on IRR, revealing for 2000 a 14.9 per cent pooled IRR of all private equity since inception of fund, with particularly strong numbers for buyouts (18.8 per cent IRR). Venture stages also delivered what was described as a ?favourable? performance with 13.7 per cent IRR since fund inception and showing the largest proportion of investment paid back to investors.

Numbers such as these allow for a useful assessment of how the industry as a whole performs. However, it is at the individual firm and fund level that gathering the data becomes far more tricky and that the IRR is more likely to be suspect. Venture Economics says that it does not release fund-specific information in order to retain access to this data from the funds: another instance of why specific IRRs continue to be regarded by those outside the industry as little more than marketing tools.

?There is a lot of gaming going on in terms of how people manipulate IRR.?

When Venture Economics recently released IRR statistics for US funds which showed a significant drop in cumulative IRR, its Vice President Jesse Reyes commented: ?I think it's the technology focus that we're seeing in the numbers.? Tellingly though, Reyes went on to suggest that the actual decline in internal rates of return could be even greater than the research indicated. ?One-third of the industry took its lumps and moved on,? he said, while the remainder had been reluctant to write down their valuations of portfolio companies. ?That's clear denial.?

Stephan Breban, senior investment consultant at investment advisors Watson Wyatt, has no illusions about IIR as a criterion when evaluating a fund. ?It's a complete waste of time,? he says. For Breban the problems start as soon as different parties start trying to come up with an IRR, as each will have their own objectives in mind ? and IRR's capacity to deliver multiple right answers means that each can produce an IRR that suits them. Breban is therefore reluctant not only to use IRR when comparing a fund with its peers, but also to accept the figure as being representative of the fund's actual performance.

IRR: yesterday's methodology?
Breban uses different methods to evaluate a fund. ?There's always an opportunity cost to investing,? he says, ?as investors will be moving capital from another asset class into private equity – it's not as if this capital has been sitting around doing nothing.? So in Breban's estimation the best thing to do is to use the schedule and value of drawdowns called by a fund from its limited partners to see what this investment capital would have returned if it had been invested elsewhere. By selecting an appropriate index from the public equity markets ? such as a global small cap index ? you can then produce a model that shows what the investments paid into the private equity fund would have returned over time if they had instead been invested in the index. This can then be compared with the actual cash and stock distributions that a fund has made, says Breban, to see whether the opportunity cost of investing in private equity has been met and surpassed.

Although many private equity firms will publicly reject the need to provide more extensive performance information over and above their self-manufactured IRR figures, in private they are finding that their prospective investors are increasingly insisting on it. Investors expect to see what cash and stock distributions there have been, are alive to the impact of ?early wins? on disclosed IRRs and are ready to apply a variety of analytical tools to evaluate a fund. And this is part of the industry's inevitable maturing. As Josh Lerner says: ?Private equity is an industry where tradition is important. And it has been something of a cottage industry until recently. Now you have bigger investors putting bigger percentages into private equity and so we are developing more sophisticated methodologies.? The time is fast approaching that IRR will have lost its talisman like status in the asset class. And few should regret it.

Effects of Takedown Schedules and Distributions on Internal Rates of Return