For general partners who ask themselves how their competitors market returns, value unrealized gains and choose appropriate benchmarks, this article might shed some light.
Following are comments and statistics on how the private equity industry markets its performance data based on an examination of 75 private equity offering memoranda (OM). The sample is made up of a cross-section of venture and buyout firms broken down by stage of investment, geography and industry focus. The study is approximately equally weighted between venture and buyout firms, with 80% representing domestically based or focused funds and the remainder foreign-focused. Fund sizes represented in the sample range from less than $50 million to more than $3 billion and from seed-stage to large buyouts. All participants’ names have been withheld due to the confidential nature of OM.
Calculation of Returns
Each firm surveyed used some derivation of an Internal Rate of Return (IRR) calculation. The firms’ five methods for calculating aggregate returns were as follows: Net IRR, Gross IRR, Time Zero IRR, Arithmetic Average IRR and Weighted Average IRR. Some firms, however, did not aggregate performance data, but instead presented gross returns on a project-by-project basis. Additionally, 17% of the OM sampled – 29% of venture firms and 9% of buyout firms – did not present any historical performance data, which might be partly because 63% of the funds sampled were first-time or spin-out funds. Surprisingly, however, several high-profile firms also failed to present historical returns despite having raised a fourth or fifth fund. Figure 1 shows an example of each of the five return computation methodologies, given the same set of cash flows. Net IRR is defined as the IRR derived from the actual cash flows to and from the limited partner at the time the cash flows took place where distributions are net of management fees, expenses and carried interest. Gross IRR represents the cash flows to and from the general partner on each investment at the time the investment or disposition took place gross of management fees, expenses and carried interest. Arithmetic Average IRR is the equally weighted average IRR of each of the individual deals. Weighted Average IRR is the weighted average IRR of each of the individual deals, weighted either by contribution or distribution amounts. Firms seem to be evenly split between aggregating cash flows on a monthly or a quarterly basis for IRR calculations.
Time Zero IRR
Time Zero IRR is an alternative method of aggregating IRRs that assumes all initial investments occurred on the same day with subsequent cash flows booked at the appropriate intervals. One high-profile firm called it the composite IRR method in its recent OM; the firm explained that the aggregate IRR assumes all investments are made concurrently and each investment is held for its respective time period. Another high-profile firm confirmed the Time Zero terminology in its recent OM, indicating that its average annual IRRs are calculated assuming that all initial investments occurred at Time Zero. An alternative use of Time Zero aggregation was used by yet another firm, assuming in its calculations that each of its funds commenced at Time Zero, with fund specific project cash flows occurring at their respective intervals.
The advantage of using Time Zero, particularly for investments stretched over a long period of time, is that it can generously boost returns because it does not properly time-weight cash flows. On the other hand, for individuals who may be marketing their personal returns interspersed with periods of non-investment activity, a Time Zero IRR calculation will allow them to aggregate projects without being penalized for the periods of investment inactivity.
The Time Zero method for calculating IRRs does not always over-state returns. For example, Figure 2 shows four cash flows. In a binary world, a fund has two investments, one that performs well and one that does not.
The investments either return one or two times invested capital in the next period, and the second investment is either made immediately following the first period or a few periods later. The Time Zero IRR calculation for the four cash flows will be the same, but the Gross IRR calculation changes depending on the initial investment and how much time expires before the second investment takes place.
Figure 2 shows that when the initial investment performs well (scenarios 1 & 3), Gross IRR is higher than Time Zero IRR; however, when the initial investment performs poorly (scenarios 2 & 4), Time Zero IRR is higher than Gross IRR. This reveals one of the characteristics of calculating IRRs where the cash flows made close to Time Zero are more heavily weighted than the later cash flows because the later cash flows are discounted by each period. Thus, the farther that cash flows occur from Time Zero, the more significant they must be to affect the IRR.
When firms calculate their returns based on a Time Zero approach, the bias of the initial investments is dissolved and all investments are equally weighted with respect to Time Zero. For those who would rather look solely at investment return multiples, all four scenarios have the same return multiple of invested capital and the same average holding periods.
Sample Results on Returns
Now that IRR definitions and calculations are understood, the result of the study, presented as a total sample and then broken down into venture firms and buyout firms, are as follows: the private equity industry standard for performance presentation is clearly Gross IRR. As supplemental data to Figure 3, 97% of the firms presenting returns in their OM reported Gross IRRs, only 3% presented Net IRRs exclusively and 31% presented multiple return calculation methods.
A comparison of the results broken down into venture and buyout firms reveals characteristic differences between the two industries. A full quarter of venture firms presented Net IRRs, compared to less than 10% for buyout firms. No venture firm used Time Zero, Arithmetic Average or Weighted Average IRRs, whereas one-third of buyout firms used one of those methods. As a rule of thumb, the sample showed that Net IRRs generally fall 600 to 1,000 basis points below Gross IRR, with an average of 750 basis points.
Sample Results on Valuation of
Another important factor in calculating interim IRRs is what to do with residual value or unrealized gains. When marketing a fund on the heels of a recently invested fund, the valuation of unrealized gains generally will determine one’s interim performance – assuming a firm has not yet had many liquidity events. In the study, 41% of firms did not present unrealized gains, which was consistent across both venture and buyout firms either because they did not present performance data or all their gains were realized. Of those who disclosed and had unrealized gains, 43% marked to market and 57% followed National Venture Capital Association (NVCA) guidelines. Of the venture firms, 61% followed NVCA guidelines with 39% marking to market, and of the buyout firms, 69% marked to market with 31% following NVCA guidelines. In addition, 28% of the total – 16% of the venture firms and 36% of the buyout firms – broke out realized returns and unrealized returns. Realized returns are the returns derived only from realized investments.
Sample Results on Benchmarking
Noticeably absent from virtually all OM was any form of benchmarking. Only 7% of those sampled used benchmarks – 4% used Venture Economics Information Services benchmarks, and 3% used the S&P 500. In other words, out of 75 OM, only three firms benchmarked their returns against the Venture Economics benchmark series and two firms against the S&P 500. Four out of the five firms that used benchmarks were venture firms. The absence of benchmarking follows the absence of reporting Net IRRs because the Venture Economics benchmark series only presents Net IRRs.
How do these industry practices compare to the Association for Investment Management & Research (AIMR) Performance Presentation Standards? AIMR is this country’s leading organization for financial analysts and portfolio managers. In addition to awarding the Chartered Financial Analyst (CFA) designation. AIMR provides professional conduct and advocacy services to the global investment community.
Private Equity Performance
Presentation Standards and the AIMR
The AIMR Performance Presentation Standards Handbook points out that Net IRRs are to be presented by vintage year. For aggregate returns, the IRR must be based on an aggregation of all the appropriate partnership cash flows into one IRR calculation as if from one investment – no Time Zero, no Arithmetic Average and no Weighted Average. Aggregate IRRs should not cross over investment strategies or asset classes. For unrealized gains, venture firms are to follow standard industry guidelines; for buyout, mezzanine, distressed, or special situation funds, cost or discount to public market comparables should be used. And finally, additional performance data that should be presented to fully meet the spirit and intent of fair representation and full disclosure are gross IRR, the net multiple on committed capital, the gross multiple of invested capital, net distribution multiple on paid-in capital and the net residual multiple on paid-in capital. Only 3% of those surveyed followed these AIMR performance presentation guidelines, although none of the firms disclosed all the additional performance data.
Apart from an encouragement to look carefully at the fine print when comparing historical performance, how do all these methodologies for performance presentation reflect on the private equity industry? Clearly, general partners like to mix and match calculation methodologies to present their returns in the best light. Additionally, return calculation disclosures frequently are obscured and sometimes absent, so it is often difficult to know what is being compared. On the other hand, what performance presentation standards are appropriate for what types of limited partners, and does one size fit all?
Some limited partners support the use of both Time Zero IRR and Weighted Average IRR as the best approach to opportunistically compare the project-by-project performance of two firms. Using Time Zero IRRs, prospective L.P.s are able to evaluate firms where projects are compared on the same timing basis; variability of investment pace is annulled. Even more opportunistically, L.P.s can look strictly at a project IRR, taking their weighted average to arrive at an aggregate return summary.
But in the end, the only performance presentation standard that reflects actual cash flows received by the L.P. is Net IRR, aggregated as if from one cash flow. These are the returns with which limited partners are most concerned. Additionally, disclosure of Gross IRR in addition to Net IRR allows limited partners to compare project returns to the premium paid to the general partners to produce those returns, i.e. the spread between Gross and Net IRR. And except for a very few allowances for special circumstances, clearly disclosed in the OM, the other return calculation methodologies merely serve to cloud historical performance.
Figure 1: Five Ways to Market Aggregate Returns
Dollars Invested and Returns
Years 0 1 2 3 4 5 Deal IRR Fund IRR
Gross & Net IRR
W Co. (50) – – 100 26%
X Inc. (50) – – 50 50 22%
Y LLC (25) (25) – 100 31%
Z Ltd. (100) 200 100%
1. Gross Total (50)(75) (25) – 350 50 34%
2% Management Fee (5) (5) (5) (5) (5) (5) –
20% Carry* – – – (10) (30) (10)
2. Net Total (55) (80) (30) (15) 315 35 24%
Time Zero IRR
W Co. (50) – – 100 26%
X Inc. (50) – – 50 50 22%
Y LLC (25) (25) – 100 31%
Z Ltd. (100) 200 100%
3. Total (225) 175 – 250 50 41%
4. Deal Average IRR 45%
5. Deal Weighted Average IRR 56%
* Assumes 20% carry after return of deal contributed capital.
Stylized example only; different cash flows will alter the methodology rankings.
Figure 2: Binary Study on Time Zero IRR
IRR – 1 2 3 4 5 6
Scenario 1 Gross 75% (1) 2 (1) 1
Scenario 2 Gross 35% (1) 1 (1) 2
Scenario 3 Gross 97% (1) 2 – – – (1) 1
Scenario 4 Gross 25% (1) 1 – – – (1) 2
ALL Time Zero 50% (2) 3
Figure 3: Sample Results for Performance Marketing
No Returns Gross Net Time Wtd Avg
Reported IRR IRR Zero IRR Avg IRR IRR
Total Sample 17% 80% 16% 12% 4% 3%
Venture Funds 29% 68% 26% 0% 0% 0%
Buyout Funds 9% 87% 9% 20% 7% 5%