Published on February 20, 2018 by Rohit Agarwal
Private equity (PE) is one of the fastest growing and largest investment asset classes in the financial market. Public market volatility and double-digit PE returns make PE much more attractive than any other asset class. According to Preqin, PE funds raised approximately USD 457 bn in 2017, higher than the previous best of USD 414 bn in 2007.
As per a recent study, investors would increase their allocation to PE in the coming years. In this scenario, it becomes extremely critical for PE fund-of-funds and other direct investors to microscopically monitor and analyze the performance of each PE opportunity to find a good fund that matches their investment strategy and target returns. Although, there are several performance-measuring tools including IRR (internal rate of return), DPI (distribution to paid-in), and TVPI (total value to paid-in) but IRR is considered one of the most comprehensive tools by industry experts.
Reasons the IRR is so effective in measuring the performance of PE investments are provided below.
Ability to incorporate irregular cash flows
A PE fund involves multiple irregular cash movements related to drawdown, distribution, dividend payments, and capital gains. A fund manager can call capital anytime from limited partners, depending on the investment opportunity. IRR has the unique ability to measure annual yield using all the underlying cash flows irrespective of their size and timing. This feature makes IRR a perfect tool to measure the performance of a PE fund that incorporates various uncertain cash flows throughout its investment life cycle.
Suitability in measuring performance under J-curve effect
Returns of a PE fund follow a J-curve, with high negative returns initially owing to cash outflows pertaining to portfolio investments and operational expenses. They turn positive only after an investment period of 2-5 years, when portfolio investments start to mature. IRR as a tool fits perfectly in this type of situation, as it considers all the negative and positive cash flows for calculating returns. On the other hand, other tools may provide distorted or unrealistic figures in this scenario.
Divulge dual information (net cash flow and time frame)
Most PE-performance-measuring tools, such as DPI and TVPI, provide only multiple returns information without divulging details about the time taken to generate a particular return. For instance, an investment generating returns of 2.5x in five years is not as attractive as one producing 2.5x returns in three years. IRR includes two important factors – net cash flow and time frame – in calculating returns, which makes it such an important tool.
Easy to calculate and compare
With the help of Excel, IRR can be easily calculated using XIRR formula and two data sets including – cash flows and the corresponding dates. Moreover, the performance of PE funds can easily be compared using IRR.
However, like all other performance-measuring tools, IRR has some shortcomings and may exhibit inflated returns in specific scenarios. At Acuity Knowledge Partners, we dive deep into cash flows and IRR calculations to identify hidden facts and provide the true performance of a PE fund. This helps our clients choose the most suitable investment opportunity in the vast PE space. Acuity Knowledge Partners has a team of highly experienced PE professionals, who provide end-to-end due diligence and performance-monitoring support to the world’s leading fund-of-funds, sovereign wealth fund managers, pension funds, family houses, and other PE investors.
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About the Author
PE and Strategic Research
Rohit has around 10 years of experience across asset management and private equity (PE). His current role involves providing support to alternative asset management teams on salesforce and e-front maintenance, financial reporting, and investment due diligence. Rohit has extensive experience across a broad range of analyses, including financial reporting, industry reports, due diligence memorandum, fund cash flow modeling, track record creation, fund revaluation models, client pitch presentations, quarterly market overview reports, and newsletters.
Prior to joining Acuity Knowledge Partners, Rohit has worked with Kotak Asset Management Company based in Delhi. He holds a Master of Business Administration (Finance) from Institute of Chartered Financial Analysts of India (ICFAI), Gurgaon.
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