This is the third article in an ongoing series on managed funds – Part 1: Using the Sharpe ratio to assess fund performance and Part 2: Identifying appropriate benchmarks for private equity funds.
“What gets measured gets managed.” – Peter Drucker
Even investors who are intimately familiar with investment funds that deal principally in publicly traded investments (hedge funds, mutual funds, etc.) frequently find themselves at a loss when trying to come to grips with other kinds of funds that specialize in nontraded assets. This is because the conventional tools for assessing the strategies and measuring the performances of portfolios of publicly traded assets have little to no utility in the context of private equity (or PE).
In a previous article, I focused on the Sharpe ratio, perhaps the most widely used measure of hedge fund and mutual fund performance, and explained its many flaws. Despite its weaknesses, it still has useful applications for weeding out overly volatile and low-performance funds. In the realm of PE, though, it is utterly useless. This is due to the fact that, with a PE fund, we have neither the numerator (the fund’s average rate of return) nor the denominator (the fund’s volatility) needed to calculate a Sharpe ratio. Because PE funds’ assets are not traded, both risk and return are punishingly difficult to calculate with any meaningful accuracy.
In practice, two performance measures have come to be used by the PE industry and accepted by investors: the cash-on-cash multiple and the internal rate of return (IRR).
How the professionals do it
A fund’s cash-on-cash multiple is straightforward to calculate. Simply take all the money that has been distributed by the fund back to its investors and divide it by the total amount of money the investors initially invested. If investors put in $1 million at the start of a fund’s life and are returned a total of $2 million five years later when the fund closes, the cash-on-cash multiple is 2x.
Calculating IRR is less straightforward. IRR is essentially the rate of return to an investor who has reinvested all dividends (at a rate of return equal to IRR) for the life of the fund. In other words, it is the discount rate that zeroes out the net present value of an investment’s cash flows. IRR is meant to provide a projected rate of return on investment.
PE professionals frequently use cash-on-cash and IRR to make investment decisions and to advertise their performances, but the latter method generally predominates. The preference for using IRR can be attributed in part to the big allocators to PE funds, such as major institutions and pension funds. These organizations are required to produce reports for their supervisors and other interested parties. Reports tend to favor measures that can be easily annualized as a percentage rate. The IRR appears to offer a view of relative performance year to year. A cash-on-cash assessment is less consistent, since it relies on exits via asset sales, which cannot be predicted with ease and are not consistent in an annualized fashion. Since reports are frequently made by officials with limited knowledge of the products they are discussing for the benefit of people who know even less, a simplified percentage rate is looked on favorably.
Yet despite its lack of apparent annualized consistency, cash-on-cash is less misleading and harder to game than IRR.
Gaming returns
Unfortunately for all the investors who set so much store by IRRs, the metric has some very significant problems. The first is structural: An IRR calculation relies on the assumption that dividends will be reinvested. But PE funds are closed-end vehicles and pay out intermediate cash flows (which are themselves often unpredictable). Reinvestment is thus usually not possible so a fund’s reported IRR is almost inevitably an overstatement of the actual rate of return.
A more worrying issue is moral hazard. Funds base their calculations on their reported net asset value (or NAV), a measure of funds’ remaining equity at the end of a given reporting period – usually quarterly and yearly. The accuracy of an IRR calculation is directly tied to the accuracy of the NAV since it is fundamentally a rate of return on equity invested. The problem is that a fund’s NAV can be extremely subjective. As the assets in a PE fund are privately held, there is no public price mechanism to allow for price discovery so valuation is in many ways an internal affair. Fund managers thus have wide latitude in measuring the value of portfolio companies and the NAV of their funds.
If fund managers choose to smooth their NAV, they can artificially decrease volatility and amplify their reported IRR. Because fund managers know major allocators are looking for funds with high IRRs and low volatility, there is a clear incentive to manufacture – or at least massage – numbers to reflect those desires, whether they are wholly accurate or not. Perversely, conservatism actually does the most to exaggerate IRR: By implying conservative (i.e., low) valuation to portfolio companies, the ultimate sale of those assets will show much higher returns.
IRR has yet another problem in that it is a measurement that cannot be meaningfully aggregated across funds. Yet allocators, such as pension funds and funds of funds, reported aggregate IRR for all their PE investments. The problem with such reported returns is that they require weighting to the various funds in which they are invested. Currently there is no industry standard for such weighting, and reports rarely include a methodology. Thus reported overall returns from PE by a particular pension fund likely carry little meaning.
Show me the money
Despite its simplicity and its inability to act as an annualized metric, the cash-on-cash return is probably the best measure of performance investors can look to when assessing PE fund performance. With so much of PE’s value tied to paper valuations, the only thing that can be measured with any certainty is cash.
Investors are best served by following the money rather than relying on dubious rate of return calculations.
