In private equity, performance reporting lies in the twilight zone

Blown away by the mythic outperformance of private equity investments? Sorry to burst your bubble.

AS ever more capital is allocated to private equity (PE), pundits and practitioners attribute PE's success to extraordinary performance. That premise is difficult to corroborate. In this four-part series, we debunk the most prevalent fables surrounding the PE industry and its supposed accomplishments.

Myth: Performance reporting is reliable

The mythography of outstanding results from PE fund managers originates in the twilight zone of performance reporting. As an under-regulated, loosely-supervised segment of the asset management industry, private equity is enshrined in secrecy.

Any marketeer knows that to attract customers it helps to mythicise a product's values and benefits. Consumerism gained mass appeal once advertisers adopted standard manipulative techniques to influence behaviours and encourage emotional purchases. Promoters of sophisticated financial products follow the same rules around communication, differentiation, segmentation, and positioning, but the complexity of these products gives salespeople more scope to lure and potentially even dupe prospective buyers.

The internal rate of return (IRR) is PE's key performance indicator and measures the annualised yield achieved over the holding period of an investment. There are two reasons why the IRR is not a reliable yardstick.

IRRs can be fabricated

Throughout the life of a fund, managers themselves determine rates of return. Only once the fund is fully realised can the IRR be labelled "final". Typically, the IRR is only known for sure after more than a decade of investing. Indeed, Palico research from April 2016 indicates that almost 85 per cent of PE firms fail to return capital to their investors within the contractual 10-year limit.

Until it is fully exited, a fund will report what is called an interim IRR, or an annualised return that includes "realised" and "unrealised" results. Once an investment holding has been sold or exited, that particular asset's IRR is deemed realised. In some cases, such as public listings or disposals of a minority stake in the business, the relevant IRR can be treated as partially realised.

Inversely, assets still held in a portfolio have an unrealised IRR. This is calculated by fund managers using data from public peers. As such, fund managers can easily manipulate the unrealised IRR and artificially inflate its value by, for example, choosing richly priced or even overrated comparables.

Most advocates of the current practice contend that evidence does suggest IRR calculations are fairly accurate. That IRR numbers are audited is usually their first argument. But valuation is not a science, it is a judgment. It is very easy for fund managers to come up with numbers that suggest better underlying performance than is justified by fundamentals, just as they can currently fudge numbers for earnings before interest, taxes, depreciation, and amortisation (Ebitda) for their portfolio companies by applying add-backs. No external auditor can assertively challenge the fund managers' views of their portfolios.

More explicitly, information released by PE fund managers is rarely, if ever, independently audited. Their accounts are reviewed by accountancy firms that can earn advisory and due-diligence fees from the same fund managers' portfolio companies. There are obvious conflicts of interest.

Data released by PE firms have, occasionally, been independently critiqued. In May 1989, for example, a Brookings Institution analyst testified before the Subcommittee of the United States House of Representatives following his review of a KKR study on that firm's performance. The transcript of the hearing is quite entertaining, diplomatically highlighting "methodological problems", "conflicting data", and the need for adjustments in KKR's report. The analyst also pointed out that the samples reviewed by KKR are small, which is a common issue in an industry that releases data on a sporadic and inconstant basis.

Other than auditors, a more independent category of critics has looked at interim IRR data. Scholars have researched the risk of overstatement. For instance, Stephen N Kaplan and Antoinette Schoar reported a correlation of 0.89 between the final IRR and the interim IRR for a large sample of PE funds. Their results suggest that the interim performance of a mature PE fund is a valid proxy of final performance.

Yet, most academic research on PE suffers from two major shortcomings. First, it depends on voluntary disclosure by fund managers. So there is an obvious bias to the available data. Only in rare instances is disclosure the result of regulatory requirements, as in the states of California, Oregon, and Washington in the US.

Second, the data set is usually a tiny sample of the total PE firm and fund universe. There is an implicit risk that the information is not representative of the whole population. Most researchers openly acknowledge that shortcoming. They need to go a step further and acknowledge that an incomplete or non-representative data set may discredit some, if not most, of their findings. The acronym GIGO - garbage in, garbage out - comes to mind.

To be clear, the reliability deficit is not specific to academic research on private equity. Few consultants, pundits, or journalists realise that data from most industry research firms is self-reported. If university students were asked to voluntarily submit their grades to prospective recruiters, who would be more likely to do so, the best students or the worst?

Another issue that applies to the academic research referenced above: From a practitioner's standpoint, the correlation is probably meaningless. Let us assume that a fund manager provides prospective investors, or limited partners (LPs), with an interim IRR of 11 per cent. But the fund manager knows that the final number will be closer to 8 per cent, which ends up being the fully realised return.

That might still generate a high correlation factor that appears academically relevant. Yet many prospective investors might well have walked away if they had known 8 per cent was the more realistic figure. The interim number of 11 per cent did the trick from the fund manager's standpoint: It fooled enough prospective LPs into investing.

The long delay in getting genuinely final and fully realised IRR numbers gives PE fund managers a fantastic opportunity to fudge interim numbers while raising subsequent vintage funds that might turn out to confirm, or not, a fund manager's performance.

IRRs can be manipulated

A much bigger issue with the IRR is that its reliance on the time value of money (TVM) makes it very easy to doctor.

As Warren Buffett warned prospective investors during Berkshire Hathaway's shareholder meeting on May 4, 2019: "When you commit the money (to private equity firms) they don't take the money, but you pay a fee on the money that you've committed . . . you really have to have that money to come up with at any time. And of course, it makes their return look better, if you sit there for a long time in Treasury bills, which you have to hold, because they can call you up and demand the money, and they don't count that (in their IRR calculation)."

There are more disingenuous ways to play with the TVM and manipulate returns. For instance, fund managers can delay the moment when they will draw down commitments from their LPs.

The subscription credit line has become an especially popular instrument in this regard. It allows fund managers to temporarily borrow money from a bank in order to delay calling funds from LPs and delay the moment when the clock starts ticking from an IRR calculation standpoint. In some instances, these credit lines can remain in use for months and potentially artificially boost IRRs by several basis points.

Alternatively, a fund manager can accelerate the upstreaming of proceeds to their LPs by carrying out partial or full realisations. Many PE firms have become experts at quick flips and repeat dividend recapitalisations.

One way to standardise reporting would be to adopt the Global Investment Performance Standards (GIPS) from CFA Institute. This set of voluntary ethical guidelines encourages full disclosure and fair representation of investment performance to promote performance transparency and "enables investors to directly compare one firm's track record with another firm's record".

Post-truth reporting

Subscription credit lines, quick flips, and dividend recaps are fantastic methods to boost returns without improving the fundamentals of the underlying assets. Slowly and imperceptibly, PE has entered a world of post-truth performance and revealed that its rainmakers can be as manipulative as they are dogmatic.

Even if fund managers called it straight every time, assessing value creation is far from an exact science. One 2016 report from Insead Business School and consultants Duff & Phelps is honest enough to admit: "The vast majority of studies leaves large residual values (of PE's value creation process) unaccounted for and tends to employ simplifying assumptions in order to assess large data sets and populate incomplete transaction information."

In conclusion, meshing realised and unrealised data blends into one single number the real returns achieved from selling an investee together with the fabricated returns of remaining portfolio assets.

And IRRs can be massaged further by delaying cash outflows and accelerating cash inflows. This all makes any analysis of PE performance by prospective investors and academics almost nonsensical.

"In space, no one can hear you scream." This popular quote from the motion picture Alien can be refashioned and applied to the veil of trade secrecy, embroidered as it is with the magic of financial expertise, that shrouds PE performance: "In private markets, no one can figure out your true performance."

  • The writer is a private equity and venture capital adviser.

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