Wrapping up my deep dive into performance assessment for private market funds, this final post aims to tackle the challenges of using the internal rate of return (IRR) as a reliable measure of investment performance. In the earlier parts, I explored the burgeoning global assets under management (AUM) in private market funds, driven largely by the belief that these assets outperform traditional investments. However, this perception is often heavily influenced by the prevalent use of IRR, which can be misleading.
Previously, we dove into the intricacies of IRR itself and why it might not serve as an accurate proxy for investment returns. Here, I’ll walk you through some corrective measures for IRR, such as the modified IRR, while also suggesting a new approach: the NAV-to-NAV IRR.
Unpacking IRR Adjustments
One predominant adjustment is the modified IRR, detailed by Phalippou in 2008.[1] This variation, employed by researchers like Franzoni et al. in 2012[2], requires selecting both a financing and a reinvestment rate, commonly set at 8% or aligned with a stock market index. It works well for short-term holdings with minimal cash flow interruptions. But for longer investment timelines—like KKR’s 48-year track record—the MIRR loses appeal, merging more with the chosen reinvestment rate.
Mirroring net present value (NPV) calculations, the MIRR shares similar limitations, offering insight only into relative performance rather than full-scale alpha differences. Our previous calculations utilized MIRR by presuming specific rates, illustrating how the measure can vary vastly with the assumptions we set.
Introducing the NAV-to-NAV IRR: A Simplified (Yet Imperfect) Solution
Throughout this series, I highlighted that the skewness in IRR often stems from high initial cash flows, influenced by survivorship bias or strategic maneuvers like subscription credit lines. A potential fix involves factoring out these early flows. A straightforward approach could be mandating firms to report returns over specific periods—such as five, 10, 15, and 20-year spans—whilst preventing reliance on since-inception IRR.
This strategy is encapsulated in the NAV-to-NAV IRR concept. Here, you’d treat the initial NAV as an investment, tally all intermediary cash flows, and view the final NAV as the ultimate distribution, calculating the IRR over this time-series. Also known as “horizon pooled return” to avoid IRR’s lingo, this strategy has gained traction in summarizing private capital performance.
Deploying NAV-to-NAV IRRs would refine performance evaluations significantly. KKR’s past 20-year IRR example, hitting about 12%, aligns well with what you’d expect from their net fee multiple—1.6, as indicated by Preqin data. Yale’s shifts to a past 20-year IRR of 11.5%, as opposed to their previously eye-popping 30%, showcase similar recalibrations in the light of this approach.
Cambridge Associates’ horizon IRRs shed more light with reasonable returns across various timeframes. For instance, the 5-, 10-, 15-, 20-, and 25-year figures stand at 18%, 16%, 16%, 15%, and 13%, respectively.
Considering the Limits of NAV-to-NAV IRR
The proposal to drop early years from calculations isn’t foolproof. Over time, as windows forward-shift annually, the distorting early cash flows won’t measure similarly and thus, become less exploitable. Yet, two significant downsides arise.
Firstly, this method discards parts of the dataset. For instance, robust returns between 1995 and 1999 might become irrelevant by 2024’s reports, with the past 25-year cutoff not accounting for them. This poses issues with shorter track records, where certain milestones simply revert to since-inception IRR, like those starting in 2002.
Secondly, NAV quality impacts outcomes, with conservative NAV assessments sometimes inflating performance figures. Think of a hypothetical scenario where $1 million investments repeat annually in a steady state. If NAVs lean conservative, IRR can falsely bump upwards, underscoring this method’s fragility.
Here’s an illustrative breakdown: with NAVs reflecting real market values over years, correct IRR hits 15%. If NAVs report at cost, IRR spikes to 20%. Cutting NAVs in half elevates returns absurdly, while doubling them brings them down—underlining how valuation biases can skew results. Recent FAS 157 regulations may harmonize newer NAV estimates with market values, but disparities in older assessments can linger.
Navigating Benchmarking
Aligning IRRs with public equity benchmarks introduces additional considerations. The debate continues over whether geometric or arithmetic benchmarks should be the reference point. Cambridge Associates opts for an IRR equivalent, or mPME, aligning with indices like Russell 3000, showcasing this complexity.
Divergences in public equity indices also play a role in benchmarking. MSCI and Russell indices often anchor evaluations with notable popularity for possessing relatively lower returns. Conversely, in academic circles, the Fama-French benchmarks persist as go-tos, scrutinized in numerous studies of active management across funds.
Crucially, when weighing pension fund performances in private equity against public equity, the exposure to different market sectors—like small versus large-cap stocks—unveils varied narratives. Also, shifts in index composition, such as excluding underperforming sectors, further complicate these comparisons.
Key Takeaways
The global rise in private market assets is undeniably tied to IRR’s allure. Yet, relying on IRR for presenting fund performances masks its limitations.
- IRR isn’t interchangeable with direct return rates: it’s a discount rate aligning an investment’s NPV to zero, with intermediary cash flows supposedly reinvested at the same rate.
- The manipulated nature of early distributions often distorts IRR results.
- Adjusting methods like the modified IRR and enforcing an NAV-to-NAV IRR approach present alternative evaluations by emphasizing past returns over static inception rates.
- Though NAV-to-NAV IRR reduces early cash flow distortions, it can inadvertently overlook data or depend heavily on the starting and final NAV’s evaluation quality.
These insights draw into focus the nuanced landscape of private market fund performance measurement and highlight the critical nature of careful, informed analysis in such evaluations.
Endnotes
[1] Detailed analysis of modifications in IRR
[2] Applications of MIRR in scrutinizing LBOs
[3] Comprehensive NAV-to-NAV IRR explanation regarding fund exits and implications at different investment levels
