Researched and written by: Megha Singh, Director of Global Strategy and Finance at Lombard Global, Inc.
Edited by: William Billeaud, President of Lombard Global, Inc.
Private Equity has traditionally reported its performance by using Internal Rate of Return (IRR). IRR is defined as the discount rate that makes the net present value of a series of cash flows equal to zero, and is used heavily as a measure for the profitability of investments. It remains the most popular performance metric as compared to other indicators such as Residual Value of Paid-in Capital, Paid-in to Committed Capital, Distribution of Paid-in Capital, etc.
The reason for using IRR as the most compelling indicator is the nature of PE funds and their lifecycle. Their performance should be measured on ‘since inception’ basis and cannot be measured on the basis of annualized returns. IRR also takes into account the timing of the cash flow, which is overlooked in the case of multiples. The fact that it is fairly straight forward to interpret makes it a popular indicator of private equity performance despite its shortcomings. As suggested by David Kaplan, author of The Silicon Boys and Their Valley of Dreams, the controversy with the IRR starts with the peculiar math which makes it a highly subjective issue.
The problem of multiple IRRs – IRR can hold its ground when the cash flows are fairly symmetrical or unidirectional, which is not usually the case with Private Equity. As soon as the cash flows fluctuate, the IRR measures begin to falter. Almost every PE fund has asymmetrical cash flows which in turn can produce multiple IRRs. With change in the direction of cash flows, the probability of generating more than one IRR solution makes it highly confusing.
Vulnerable to manipulations – The fact that IRR calculations are highly sensitive to the nature of cash flows (i.e. higher cash flows early in the investment period can boost IRR), leaves the entire methodology highly vulnerable to manipulations. As an example, a return of $2 million in the initial 2 years of the investment would have far more bearing on the IRR results than a loss of the same amount in the 10th year, thus leaving it open to manipulation and faulty representations. This premise has been clearly addressed by Arleen Jacobius in her article, “IRR may overstate PE returns”.
Reinvestment Assumption – The HBR article “The Truth about Private Equity Performance”, addresses the premise that the capital will be reinvested in the projects which have rates of return similar to the IRR generated up to this point in time. This is not always true. The IRR calculation assumes that the cash flows are reinvested in projects with equal rates of return, thus overstating the returns.
The Solution (straight out of Finance 101) is Modified IRR (MIRR). This is similar to IRR but instead of assuming the reinvestment rate, MIRR specifies a fixed rate of investing and borrowing. Thus MIRR enables us to address the larger pitfalls of IRR and the issues of funds being helped or unfairly punished by the IRR reinvestment assumptions. As highlighted by Koci, author of “Inside Private Equity”, when IRR alone cannot be the true measure of private equity investment performance and needs to be supplemented by some other measure, the MIRR takes into account the pitfalls that IRR overlooks.