The Internal Rate of Return (IRR), an annualized, money-weighted return, is one of the key return metric used within the private equity industry. Expressed as a percentage, it can seemingly be used to compare performance from manager to manager or fund to fund. In reality though, it is not always that straightforward and IRRs alone are not an accurate representation of performance.
Take a look at the chart below with Managers A to D listed across the top. As you can see, if you just take IRR into account, Manager A is clearly the outperformer. Even when TVPI (the return of cost multiple) is applied you could still classify Manager A as a winner, but Manager B has produced an identical multiple – returning the same ratio of capital but at different times to produce the variance in IRR.
Performance is even more accurately represented when Profit, Holding Period, and Cost are revealed. Gaining insight into this level of detail allows you to understand a manager’s performance better and assess the risk of investing with them depending on your goals – do you want a manager that is known for strategies that create slower returns but a larger monetary profit? You also will want to understand how likely it is for a manager to return capital in a shorter period of time than expected. Are you exposed to risk by being under allocated to private equity and so having to source new funds and managers to invest in? Or do you view this as the opportunity to put that money to work elsewhere?
Even more curiously, two identical IRR numbers will not always be derived in the same way. As you can see below, getting an early win (returning capital quickly) can help to boost the IRR.
This highlights why when measuring private equity returns, high level numbers can be a good way to select those to investigate further, but other metrics must be taken into account. These high-level numbers also only tell you what the manager returned. The real goal of due diligence is to understand how they returned this and how repeatable this is.
Investors who are required to select and monitor investment managers should develop a basic understanding of investment statistics. Quantitative tools can provide you with good insight that you can use in your qualitative interviews with managers and when monitoring your investments.