LPs Reconsider the Value of IRRs –

Increasing the pressure on beleaguered general partners, a new group that represents most institutional limited partners is demanding a different reporting system to track the performance of private equity funds.

If it has its way, the Institutional Limited Partners Association (ILPA) will do away with the traditional method of using internal rates of return (IRRs). “IRRs are meaningless,” says Richard Hayes, chairman of the newly incorporated ILPA, which counts two-thirds of all institutional private equity investors as members.

Instead, the ILPA wants VCs to adopt a “cash-in and cash-out” policy. “Although IRRs are an indication of how a fund is doing in the interim, at the end of the day, if I give you $1, what we care about is that we get $3 back, and when,” Hayes says.

Hayes revealed the ILPA’s proposal at a March meeting of the investment committee for the California Public Employees’ Retirement System (CalPERS). “Cash-in and cash-out’ is what really matters because cash is what pays the benefits and helps retirees,” he says.

The investment committee voiced immediate support for the ILPA’s proposal. Hayes, who is a senior investment officer for the CalPERS alternative investment program, is scheduled to return to the committee with a formal recommendation in June.

Several LPs contacted by Venture Capital Journal say the proposal makes sense. “It would be a lot easier on the LPs that have hundreds of funds to look at if there was a single benchmark everyone used,” says one California-based institutional investor. “We want to get GPs on the same formula so there’s less opportunity to manipulate returns.”

While some GPs see the merit of the proposal, there is no consensus among them. The National Venture Capital Association (NVCA) has not taken a stance on the issue nor has it ever rallied for standardized terms in partnership agreements or performance measurement standards. However, John Taylor, vice president of research for the NVCA, says that neither IRRs nor a cash-in and cash-out standard can stand alone as a performance gauge. “Those numbers go hand in hand,” he says. “The only valid measure of portfolio performance is after the fact.”

Hayes argues that IRRs are inconsistent and misleading. Since IRRs are based on valuations of privately held companies, two funds can calculate different valuations – and different IRRs – for the same investment. A cash-in and cash-out reporting standard could eliminate those inconsistencies with a simple and transparent method of calculating returns, he contends.

Switching to a different reporting system wouldn’t be difficult. Venture Economics (VE), a New Jersey-based industry research group (and also the parent company of Venture Capital Journal), already calculates a distribution to paid-in ratio and includes the standard in its fund performance reports to LPs. When it reported private equity performance results for the third quarter of 2001, VE used both standards for the first time in its history.

VE isn’t the only source for such data. Cambridge Associates of Boston also calculates the “cash-in and cash-out” standard for LPs. San Francisco-based VentureOne, a direct competitor to VE, does not track fund performance.

“In the venture business, there are some standard ways to report an increase in valuation – to carry the investment at its value in the most recent round of funding,” says Lindsay Jones, a Boston-based partner with Advent International. “But when there’s a decrease in valuation – what we’re seeing a lot of these days – whether the venture firms are taking reserves against troubled investments in the same way, or how they’re valuing those investments, there’s no real standard.”


In a rocky period for GP and LP relations – when VCs are slashing management fees and personnel in order to cut costs and returning capital to their investors – the ILPA’s proposal may be the group’s first move aimed at getting GPs to atone for the sunk investments of the late 1990s.

“LPs are our customers, so they get to determine our performance standards,” says Micah Avni, a partner with Jerusalem Global Ventures in Israel. “This is fair enough. On a personal level, I prefer more transparency. The good guys only stand to benefit from this.”

But, Avni adds that it doesn’t make sense to throw out IRRs altogether. “Initial investments are based on the team and their personal track records, and to a lesser extent on focus, strategy and proprietary deal flow,” he says. “But how will LPs make decisions about Fund II and Fund III, which are still too young to be measured on a cash-in and cash-out’ basis? In these cases, it probably makes sense to stick with IRRs but adopt an industry standard for calculating them.”

According to the ILPA’s proposal, invested cash would be measured against what is returned to the LP in the form of liquid stock on the day the stock is distributed to LPs. Basically, it’s a vintage-year approach that will look at funds in the years six through 10 and then compare the returns of a given fund with its peers, once the investment capital has been deployed and cash and profits already are being distributed.

While the ILPA’s proposal may standardize how investments are valued, it will not eliminate the industry’s reliance on IRRs as a performance measurement standard before a fund matures and for first-time funds.

Hayes has been among the most vocal and forceful in demanding transparency in the private equity industry. Since taking over as head of CalPERS’ $20 billion private equity program in July 2001, he has posted fund performance reports on the pension fund’s Web site. In March, he distributed a list of capital calls to CalPERS’ investment committee along with his group’s monthly performance report. He plans to add distribution reports to that list over the coming months.

Hayes took on the chairmanship of the ILPA as a means of organizing LPs and promoting research and standards throughout the private equity industry. The ILPA represents more than 100 organizations worldwide, and 80% of its members hold assets greater than $5 billion.

Email Carolina Braunschweig at: