It is hard to compare the performance of private equity investments 

Key points

  • There are several flaws in the internal rate of return (IRR) as a measure of performance
  • The money multiple and the public market equivalent (PME) provide alternative approaches
  • Private equity investments incur higher management costs and can have complex cashflows that skew return measures

Questions are being raised about the understanding and analysing of private equity returns data. How can one determine in which general partners (GPs) to invest? As Peter Wilson, managing director at HarbourVest Partners, says: “Many GPs claim to be top quartile on some metric.” Comparisons between private equity GPs is not the only concern. There are many difficulties that make comparisons with public market returns hard. Yet these need to be tackled for institutions to make well informed asset allocations decisions between private and public markets.  

The Yale Endowment has been seen as the leader in alternative asset investment based on an aggressive stance in private equity. It had a 30.4% reported annual return from its launch in 1973 to 2011. But, as Ludovic Phalippou, a professor at the University of Oxford’s Saïd Business School, pointed out in a 2011 paper, earning 30.4% a year for 38 years would mean a return over that time of 24,000 times. Such performance would imply $1m in 1973 would have grown to $24bn by 2011. But the latter figure was more than the size of the whole Yale endowment at the time. Understanding why that has not been the case is essential for any analysis of private equity performance as well as comparisons with other asset classes.

Mathematic flaws
The problem that Phalippou highlighted is that the internal rate of return (IRR) calculation used to describe returns has numerous flaws that makes it a poor metric for describing actual returns. 

An IRR figure can be described as the discount rate which makes the net present value of investment and return cashflows sum to zero. It assumes that all cashflows during the period are reinvested at the same rate given by the IRR. 

In practice, if a fund spins out an investment quickly at a multiple of the initial investment the IRR could be 40% or more. However, investors cannot be assumed to be able to reinvest the proceeds at that figure. That is why the money multiple, which is merely the multiple of the initial investment obtained on sale is often used alongside IRR calculations. This can be defined as the ratio of distributions to paid in capital (DPI). 

Alex Scott

Alex Scott, a partner at Pantheon, explains that what matters when it compares private equity funds is a combination of IRR and money multiples. In general terms as regards a private equity fund, a net money multiple after all carried interest and fees in excess of two times would typically be seen as an attractive return. A respectable IRR would be anything above 12% in a fund with a lifetime of 15 years at maximum with underlying investments typically held for between three and six years.

Subscriptions blur figures
What can improve or distort IRR figures, is the increasing use of subscription line financing by GPs. This is a credit line taken out by GPs secured on the committed capital from limited partners (LPs). This ostensibly is to reduce administration burdens on LPs by having just one capital call per year with other short-term capital requirements catered for through the credit line. What it means though, is that the timing for an LP’s capital to be called up is delayed, increasing IRR figures. However, the investments are not any better, and if the funds are not being deployed elsewhere the LPs will not benefit.

andrew brown

As a result, Andrew Brown, head of private equity manager research at Willis Towers Watson, goes so far as to see IRR calculations as being of less relevance. A judicious use of subscription lines can alleviate the ‘j-curve’ characteristics of private equity and improve IRR figures. But, as he points out, taken to extreme, GPs could finance new investments through realising old investments financed by subscription lines pushing IRR figures to infinity for investors. Moreover, there is a danger for investors in the overuse of subscription lines. If a GP uses them to finance investments which then fall in value, an LP may be being asked to pay 100 for an investment only worth 50. Is it fulfilling its fiduciary duties by doing so? 


“Some investors will say no and that becomes a huge risk for the fund. Subscription line financing has not been tested in a downturn,” says Brown. He adds that the managers seen with top quartile performance are often those who have been the most aggressive users of this technique.

Yet, says Scott, Pantheon’s clients are not averse to GPs using subscription lines, albeit with limits on how much and for how long. “We believe that the best practice for LPs is to have IRRs reported pre- and post-subscription lines and, generally speaking, that tends to be what the most sophisticated GPs provide,” he says.

Hidden costs exposed
The biggest challenges may not even be ensuring fair comparisons between private equity firms. Instead, says David Sarfas, global head of private equity at MUFG Investor Services, there could be transparency and hidden costs. In 2015, for example, the Securities and Exchange Commission, the US securities regulator, fined KKR. As Andrew J Ceresney, director of the SEC enforcement division, says: “Although KKR raised billions of dollars of deal capital from co-investors, it unfairly required the funds to shoulder the cost for nearly all of the expenses incurred to explore potential investment opportunities that were pursued but ultimately not completed.” 

David Sarfas

Hidden costs can also be a problem with the capitalisation of expenses such as set-up fees. A decade ago, any fees could have been capitalised, but today it has become difficult to do so. 

“There is clearly an industry push for fees to be recognised immediately and flushed through the P&L and that creates a lower cashflow immediately, adversely impacting IRR figures,” says Sarfas. As fees can total between 1% and 5% of total deal value, the impact on cashflows in early years can skew IRR calculations. “Transparency, subscription lines and hidden costs are the three big areas which can skew IRR figures”.

Comparisons hard
For institutional investors, finding appropriate metrics to compare private equity firms is just one issue. Of perhaps equal or higher importance is how best to compare private equity returns with those seen in public markets. Private equity is just unlisted equity and any claims of lower volatility are a reflection of illiquidity rather than of different economic characteristics. The most appropriate measure appears to be the public market equivalent (PME). Here, private equity market cashflows are compared with an equivalent investment in a public market benchmark. It is assumed that capital calls and distributions generated by the private equity fund are invested or divested from a portfolio invested in the benchmark at identical times. Variations of this idea can be used to calculate performance relative to public market benchmarks on a like-for-like basis.

Given the contraction in public markets with a dearth of new issues, it is not surprising that investors are turning to private equity in the search for growth. But private equity investments do incur higher management costs and can have complex cashflows that skew return measures. Understanding what makes a good private equity investment relative to others and relative to public market investments has for long proved to be controversial. But to pour money into private equity without fully understanding the issues seems folly.

Private Equity: Finding the right metric