Share With
Anyone allocating capital wants to be able to compare the returns of asset classes against each other. However, this is not always a simple exercise.
Private equity performance in particular is often seen as opaque relative to listed markets. One reason for this is the use of internal rate of return (IRR) as a measure.
However, the reason private equity uses IRR is not to be obtuse. It is the only way to accurately reflect the return that limited partners – investors – receive on their money. And it’s important to understand why this is so different from how returns are calculated in listed markets.
Firstly, if an investor puts money into a unit trust, that goes to work immediately. They get allocated their units, and they will have exposure to exactly the same underlying securities as everyone else in the fund from day one.
If that investor wants to increase or decrease their holding, they can do so at any time. In simple terms, the difference between the amount they put into the unit trust and what their investment is currently worth will always be their gain or loss.
Private equity works very differently. This is the reason why the majority of private equity funds are closed-ended funds as opposed to open-ended funds like unit trusts.
When an investor makes their commitment, that money doesn’t get deployed straight away. The fund will only invest it when deals are closed, and this could take years to happen, while management fees are drawn on a quarterly basis. Investors also can’t withdraw their money at any time. They are locked in until the fund finally exits and wraps up.
The IRR calculation is the only way to cater for this cash flow profile. It is able to take into account different amounts deployed by the fund managers at different times.
An additional difference is that a private equity fund is not priced daily. It might provide quarterly or semi-annual valuations, but even those are really theoretical. In the early days of a fund, the returns can and often will reflect a “negative” return when no new investments have been made but fees have been drawn. The fund only truly delivers a return at the end of its life, when investments are exited and cash is returned to the limited partners.
A useful way to think about this is the difference between buying an established house and building a new one.
If someone buys a house for R2 million, that is their capital deployed. If they don’t spend any additional money and in a year’s time their house is now valued at R2.2 million, it’s a simple calculation to determine the return on their investment.
Someone who opts to build their own house is doing something very different. They might buy a plot for R1 million, but they then have to make a series of ongoing investments to get the house built. They have to lay the foundations, build the structure, buy the fittings and fixtures, put on the roof, paint the walls and so on.
Even before breaking ground, there will be money spent on architectural plans, municipal approvals etc. This is akin to fees drawn ahead of new investments in private equity. If the value of cashflows were measured at this point, they would be significantly less than the value of the plot, giving what looks like a negative return.
If it takes two years to build this house, it would make no sense after the first year to compare it to R2.2 million property owned by the person who bought the already established house. The complete house will have a higher value at that point, but that doesn’t necessarily mean that it’s better. That can only be determined once the new house is complete.
Private equity works along the same lines. In order to realise value, fund managers need to spend capital upfront. That means that for some time, the IRR is likely to be negative. But that doesn’t indicate a realised loss.
Because the cash flows in private equity are so significant – like the outlays someone has to make in building a house – you can’t do a simple calculation of current value minus invested capital to get a return. That is only possible in the listed space.
It also means that private equity funds are difficult to compare against each other until the end of their lives. For example, you may find two funds that started at the same time, but they have very different investment profiles. One might have closed a number of deals early, and be fully invested by year two. The other might only close all their deals in years four and five.
If you then compared them in year six, all the value accretive interventions in the first fund may already be delivering positive results, and that would be reflected in a higher valuation. In the second fund, the value accretive interventions haven’t yet materialised, but that’s not indicative of where things might end up. The second fund may have invested in much more innovative, faster growing businesses that ultimately produce a higher return.
IRR is the best way for private equity to capture these differences. It may seem confusing at times, but ultimately it allows funds to reflect the true value they have created for investors.