Apples and Squirrels – IRRs vs CAGR

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The internal-rate-of-return is the traditional way of measuring returns in private markets (where cash-flows occur into and out of partnerships) but its shortcomings as a measure are one big reason to be wary of private markets performance, more on that here.

It can be a bit like comparing apples with squirrels.

One of several issues with private equity highlighted by a popular paper by Ludovic Phalippou recently is the big issue of the of Internal Rate of Return being used as a metric, and being erroneously compared to geometric returns of public markets.

I took a deeper look at this and realised I REALLY do not understand IRRs at all…

I suspect 95% of investment professionals are in the same position, but very few would actually admit this – which causes its own problem and allows bad comparisons to continue circulating unchallenged.

Here’s the example. Investor A invests £100 in a fund, gets 100% return in the first year, then 10% each year up to the tenth year. Work this out as a compound geometric return and it comes out at 16.8%p.a. the initial £100 growing to £472

Investor B does the same thing but in a private equity structure that takes in 100 at time zero and pays out 472 in year 10. The IRR is …. 16.8% (ie, the same). So far so good … but bear with me

Now we play with the timing of cashflows –

Investor C is in a fund which takes in £100 aas before then pays out £100 after the bumper 100% return in the first year (leaving £100 in the fund). Then makes 10% each year on the remaining £100, paying this out each year. Then the remaining £100 is paid out in year 10. So the actual returns for all intents and purposes are the same as previous examples. The IRR? 34% p.a.

[edit: several readers have rightly pointed out that getting your money back early (with interest) is a good thing and that investor C should probably be happier than investor B. I don’t disagree, but probably not by as much as the IRR would have – a claimed return of 34%p.a vs 17% p.a. Shows how tricky the problem is when you have separate timings of cash-flows and investment returns. ]

You might say these numbers are totally contrived, but not so fast. Yes the 100% return in the first year is extreme, but this is not beyond the realm of possiblity and actually quite similar to early track records of many large funds, who enjoyed one or two “home runs” early on, particularly in Venture Capital.

And what’s more, returning to our example, even if you had 100 years of 10% returns in there following the initial 100% return, the IRR would still come out as 30% (even though the geometric average would be ~10%). It’s all skewed and anchored to a high number by that initial 100% return, hence why Phallipou shows Apollo’s (and other) since inception IRR perenially showing as 26%, unchanged for decades, which is technically correct, but meaningless in terms of the obvious comparison to the 8%p.a. or so in public markets – like comparing apples with squirrels.

If you’d like to take a look at the maths you can do so in a google sheet here

This is just the start of the issue with IRR’s however. As Ivashina and Lerner point out in their book Patient Capital, there are other practices that artifically “juice” the IRR which are at least as bad. One of these is the use of subscription lines. This means that effectively a private equity fund can acquire an asset using a bank loan, and leave their investor’s assets undrawn. When they are close to selling the asset, they could then draw investor’s assets, repay the bank loan, sell the asset, realise the entire gain and quickly repay the investor. This would create a spectacular bump to the IRR number be earning the full return over a very short space of time but has created no extra value to the investor.

So what’s the solution?

Well, the short answer is to use simpler comparisons which are harder to manipulate such as the Multiple of Money (MoM). This is simply the ratio of how much money you got back to how much you put in. So if you get £200 back for £100 you put in, that’s a 2x MOM (and a pretty decent return, depending of course the timeframe over which it is earned).

Two important caveats:

You need to make sure this is being quoted AFTER all fees and carry.

An average MoM according to large private equity datasets is around 1.5x, according to Phallipou which is very similar to what public markets have generated over comparable (5 year) time periods.

Another approach is the Public Markets Equivalent (PME) which endeavours to calculate a ratio to express the private equity performance relative to what could have been achieved in public markets. A PME in excess of one indicates that the private equity investment outperformed the public markets.

Care is also needed to ensure the correct public equity benchmarks are used, canny managers can easily game the comparison by choosing an easy target (such as choosing MSCI World for a US-focused manage, picking the Russell 2000 instead of the S&P 600 etc).

Takeaway – you could do the world (and your investors) a favour by never letting anyone get away with comparing an IRR with a compound return, and always insisting on MoMs.

If you liked this you might want to check out one reason why this equity rally might not be overdone and The Rise and Rise of Private Markets.


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