This essay was written for CFA Institute, a global association of professional investors. It was first published on the Enterprising Investor, which offers practical analysis for investment professionals.
Tall tales. They are part of the folklore of all cultures. Think of Paul Bunyan; the “big one that got away;” and even a few stories from Garrison Keillor’s Lake Wobegon, “where all the women are strong, all the men are good-looking, and all the children are above average.”
I was reminded of tall tales recently when a few of my colleagues and I were talking at an investment conference about how even sophisticated investors have been sold tall tales. Specifically, we discussed how private equity internal rate of return (IRR) and volatility calculations can sometimes be misleading.
How does this play out?
It might best be described by starting with a true tale.
Recently, my firm was asked to review a private equity presentation pitched to a wealthy family. It included pages that touted historical IRRs and standard deviation, or volatility, as compared to public market indices.
What were the problems?
The IRR and volatility calculations were technically correct and all was legally disclosed based on accredited investor rules.
As we often find, however, the IRRs were significantly higher than the actual cash returns investors received. The presentation of volatility, or risk, was also low and unrealistic as compared to public markets.
How can this be?
Investment disclosures state that past performance does not guarantee or indicate future returns, but this is exactly what IRRs can do. IRR calculations assume that future investments will achieve the same returns as earlier investments. Realized cash distributions are assumed to keep earning the same returns in the future for the complete life of the fund or private investment.
Yes, this can get a little complicated, but the issues are ones the industry has been warned about for more than a decade by top thought leaders.
As far back as 2004, McKinsey & Company produced a white paper detailing the problems with IRR calculations titled “Internal Rate of Return: A Cautionary Tale.” It included this question related to the use of IRRs:
“Why do finance pros continue to do what they know they shouldn’t?”
Beyond conflicts, which we all can have, maybe some finance professionals simply don’t know.
Ignorance is never an excuse, but as an example, McKinsey found that “in an informal survey of 30 executives at corporations, hedge funds, and venture capital firms, . . . only 6 were fully aware of IRR’s most critical deficiencies.”
They then go on to discuss the problems IRRs can create:
“Unrealistic expectations . . . [and] dangerous assumption[s].”
To drive this home, below is my version of a chart from the McKinsey study. It highlights two different methods of projecting, or reporting in the case of many historical PE fund presentations, the returns of the same $10-million investment.
Scenario A uses an IRR methodology, which assumes that each $5 million realized cash flow is reinvested in a manner that will achieve the 41% IRR.
Scenario B assumes the $5-million cash flows can be reinvested at a more modest but still relatively high return of 8%.
Source of data and methods: McKinsey & Company, but recreated by Preston McSwain
Hopefully this helps highlight a key problem that McKinsey warned about.
To assume “that interim flows can be reinvested at high rates is at best overoptimistic and at worst flat wrong.”
In the above example, presenting a 41% annualized IRR would be technically compliant, but as McKinsey states, the more realistic 24% “return is nearly 50% [lower].”
Because of these issues, we commonly see presentations that boldly highlight historical IRRs, even though investors have never actually received the equivalent cash returns. Is this why McKinsey used the words “dangerous” and “wrong”?
I’ll let you decide.
To be fair, there is no simple way to calculate private equity fund returns. If you google “IRR Private Equity (PE),” you will get pages of results that discuss the pros and cons of using different methods to evaluate the performance of PE funds.
As an example, Howard Marks, in a paper titled “You Can’t Eat IRR,” lists seven different ways to judge private equity performance.
He properly states that to get it correct, a “complex, multi-dimensional analysis is required,” but he also details his own cautionary IRR tale.
Marks explains that he was asked to evaluate an investment made by a friend in a private equity fund of funds. His friend had committed $750,000 to the fund, $600,000 had been called, and the materials stated that the fund had produced an annualized IRR of 27.1% since inception. As Marks says, “So far, pretty good.”
Unfortunately for the fund, he then mentions the unrealistic expectations and assumptions the presentation created.
“The IRR of 27.1%, if applied to his contributed $600,000 (forget his committed $750,000), would have produced $1,142,000 of gains.
“And yet, [his friend had only] $273,000 of actual gains.”
This prompted Marks to end his story with an iconic question:
“Where’s the beef?”
What about the risk?
We see many presentations suggesting that the risk or volatility of private equity as an asset class can be lower than that of public markets. However, as Erik Stafford from the Harvard Business School wrote in a recent paper, private equity presentations often don’t discuss how accounting and valuation methods can create “‘hidden” or “smoothed” risks.
As with other studies, his research is detailed and technical, but just as pictures paint a thousand words, so do the following quotes:
Private equity investments are often not valued more than once a year — sometimes less — and can be subjective. Yet these same investments are commonly compared to public equity investments, which fluctuate second by second on global stock exchanges.
Just because you don’t account for the value of something more often than once a year doesn’t mean its value in the eyes of a buyer isn’t subject to constant large or quick changes. Plainly said, the comparisons are not apples to apples.
Some private equity funds and private investment opportunities are top-notch and worthwhile from both a risk and return perspective.
As asked, however, by the authors of “The Truth About Private Equity Performance” from the Harvard Business Review: “[Does] overstated private equity performance [and understated risk] . . . partially explain why investors continue to allocate substantial capital to this asset class?”
I think so.
What should investors do?
Ask probing questions with the understanding that even though presentations can contain appropriate disclosures for accredited and sophisticated investors, they might not be fully transparent and can obscure a lot with complex disclosures.
As researchers at McKinsey wrote, accounting and return calculations can sometimes “make bad [investments] look better and good ones look great.”
Simply put, even though many private equity presentations might seem like they are from Lake Wobegon, it would be wise to remember that they are not all above average.