The parallel universe of private equity returns

If IRR metrics had any sound basis in fact, we would all be as rich as Croesus

Jonathan Ford


US savers may soon be able to invest their 401(k) retirement accounts in private equity, but should navigate the numbers carefully © Getty Images


Ever wondered about the extraordinary performance figures that listed private equity firms trumpet in their official stock market filings?

Take, for instance, the latest Form 10-K issued by Apollo, one of the world’s largest buyout groups. This claims that its private equity funds have “consistently produced attractive long-term investment returns . . . generating a 39 per cent gross internal rate of return (IRR) on a compound basis from inception through December 31, 2019”.

Or how about the one from KKR, which says it has “generated a cumulative gross IRR of 25.6 per cent” since the firm’s inception back in 1976?

It’s not just the eye-popping scale of these returns that captures the attention. It’s their amazing “since inception” consistency. Not only do the firms generate stratospheric numbers — far higher than anything produced by the boring old stock market — but they can apparently do it year in, year out, with no decay in returns. 

A recent study of the back catalogue of these SEC filings by the Oxford academic Ludovic Phalippou reveals the extraordinary durability of their performance.

Take Apollo, for example. Its long-term IRR has barely moved from the 39 per cent level over the past several decades. True, it did hit 40 per cent in 2008, before dropping back by a full percentage point the following year.

But since then it has been like a stuck record. Financial crises? Great recessions? Market fluctuations? It seems that nothing can knock it off that 39 per cent.

It’s a similar story with KKR. The firm's IRR since inception has fallen by just 0.7 of a percentage point in the years since 2007 and, at 25.6 per cent, remains barely below the 26.1 per cent return generated by its early “legacy” funds between 1976 and 1996.

Buyout bosses like to talk up this consistency, as if it demonstrates private equity’s “edge”. The reality is that these consistent IRRs show nothing of the kind. What they actually demonstrate is a big flaw in the way the IRR itself is calculated. 

Baked into the formula is an expectation that all cash distributions can be reinvested at the same rate that the fund in question is earning.

Even when measuring the returns of a single fund over its own lifetime, this is a heroic assumption that can lead to returns being materially overstated. But apply it across multiple funds, compounded over many decades, and the results swiftly become completely unhinged.

To see how, imagine that KKR made a distribution of $100m in 1980 on a fund that generated a 25 per cent return. Compounded over 40 years at that assumed high reinvestment rate, the pot would now be worth a theoretical $752bn.

Plug that into your since-inception IRR and, as Prof Phalippou points out, with time the results will be ever more firmly driven by those enormous notional sums clicking out their theoretical percentage uplift every year. Indeed, probably KKR could lose every penny of its current $30bn of private-equity funds and its since-inception IRR wouldn’t change very much. 

Of course it is easy to see why the industry doesn’t mind headlining a number that is about as meaningful as the pig-iron output statistics the USSR blared out in its heyday to advertise its industrial prowess. After all, these IRRs support its central claim to deliver high and stable returns. (To be fair, it should be stressed that private equity firms do offer other more meaningful performance measures although they make few of these publicly available).

But what’s concerning is the ease with which this mathematical circularity has been allowed to create a distorted impression. The main audience for private equity to date has been large, so-called “sophisticated investors”. The fact that these absurd numbers still get headline exposure makes one wonder whether these investors understand them. That is disturbing.

Even more worrying is the way that policymakers appear to have set these financial pig-iron statistics in stone. The industry standard for reporting — the Global Investment Performance Standards — actually makes it mandatory for private equity to report a since-inception IRR or “money-weighted return”.

The Chartered Financial Analysts Institute, guardians of these standards, asserts that GIPS is based on “the principles of fair representation and full disclosure”. Really? 

If IRRs since-inception could be banked, our pension funds would all be as rich as Croesus. Manifestly, if sadly, that is not the case.

Realistic numbers matter. The US authorities are thinking of letting the American public loose on private equity with their 401(k) pension plans. Retail investors need to know what they are getting into. It’s time the way private equity reports performance was rethought.

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