None of this is investment advice. Private equity can be a really important and dynamic piece of an investment portfolio and is an asset class that our firm allocates to for the right clients in the right context.
Business owners and high net worth families often have access to investment opportunities that their mass affluent counterparts do not. Over the past several years, private equity funds have raised an incredible amount of capital from investors, institutions, and foundations. Some of the largest and most sophisticated buyers in the world allocate to these vehicles which entices individual investors to follow suit. If it's good enough for Yale's endowment, isn't it good enough for me?
My goal is not to categorize private equity as "good" or "bad," but to explore how performance reporting is dramatically different (and misunderstood) relative to public market investments. Let's start with a simple example:
How has SPY (the S&P 500 ETF Trust) performed the past ten years?
On an annualized basis, SPY has a total return of 13.17% ( as of market close on 11/25/24) over the past ten years. Moreover, I can see what the performance of the fund is each calendar year that it has been in existence. This is because the underlying holdings are publicly traded stocks that are marked to market on a day-by-day, minute-by-minute basis.
If I had invested $1,000,000 ten years ago, I am confident that my return on investment (ROI) would have been 13.17% annualized.
Lately, I have been getting more questions along the lines of:
"My friend is investing in a private equity deal. He told me it has a 30% annual rate of return. Is that something we can participate in?"
Remember, this is not a 'good v. bad' conversation, so before I even analyze the fund company, the portfolio, etc., I make sure that everyone understands what these performance figures actually illustrate.
Private equity funds do not have the luxury of holding stocks that are marked to market on a constant basis. Rather, their portfolio values are generally only updated when a transaction happens. Additionally, cash is periodically flowing in and out of the investment in the form of capital calls and distributions. These features make a "normal" ROI calculation impossible. It is common for private equity funds (and venture, private debt, real estate, etc.) to use internal rate of return (IRR) as a stand-in for ROI.
So, when that friend is referring to a 30% annual rate of return, it is likely they are quoting IRR since inception. Let's use the time period in the example above to illustrate why that is important:
Year | Cash Flow |
0 | -$1,000,000 |
1 | $200,000 |
2 | $200,000 |
3 | $200,000 |
4 | $200,000 |
5 | $200,000 |
6 | $200,000 |
7 | $200,000 |
8 | $200,000 |
9 | $200,000 |
10 | $200,000 |
IRR | 15.10% |
In the above example, we illustrate a private equity fund that operates over a ten year time horizon. My original investment of $1,000,000 cash flows $200k per year until the end of the hold period for an IRR of 15.10%. It may not be a 30% annualized return, but I still beat the S&P 500. What does a 30% annualized return look like?
Year | Cash Flow |
0 | -$1,000,000 |
1 | $1,300,000 |
2 | $0 |
3 | $0 |
4 | $0 |
5 | $0 |
6 | $0 |
7 | $0 |
8 | $0 |
9 | $0 |
10 | $0 |
IRR | 30% |
I'm hoping that you are scratching your head at this point. In the first example, you receive $2m when the fund is distributed at the end of 10 years for an annualized IRR of 15.1%. In example 2 you receive $1.3m back for an annualized IRR of...30%???
There are several important (and often incorrect) assumptions that the IRR calculation makes, but the biggest is that distributions are reinvested at a rate of return equal to the IRR. In the above example, if $1.3m is distributed to me at the end of the first year, I may not care. But if the fund has a 10 year lockup and I receive my distribution at the end of the 10th year, am I going to be happy with my "30% annualized rate of return?"
Here is how this could play out in practice and how it affects you.
Let's say a well-known company establishes a fund in the mid-90's. During the tech run-up, they were able to book some big wins early. Assume $100m raised in '95 was able to distribute $50m in'96, $75m in '97, and $100m in '98 and '99.
After the Dot Com bubble bursts, they don't distribute any more capital, but continue to raise money from investors for the next decade. An investor who buys into the fund in 2000 would go an entire decade without receiving a dime, all while the parent company parades around town advertising a "60% annual rate of return!"
How do you protect yourself?
Keep your B.S. meter up. If it sounds too good to be true, you have some more digging to do.
Use alternate return methods.
IRR since inception is a killer as you can see above--it relies heavily on early returns that may not be relevant to you. Trailing 5-year IRR or something similar could be a step in the right direction.
'Investment multiple' provides some helpful context. In the first example with a 15.1% IRR, the investment multiple is 2.0x. In the second example with the exorbitant IRR, the investment multiple is only 1.3x.
A public market comparable is a more complicated calculation but would have you apply the cash flows from the PE fund to a publicly traded index (S&P 500 etc.) to illustrate performance relative to a benchmark. This is dramatically different from comparing the fund's IRR to the public market's ROI.
Work with an investment advisor that you trust.
Understand where the incentives are. Is this a commissionable transaction? Does it fit into your overall strategy?
"Blah blah blah he's never steered me wrong before," is fine and I understand that, but does he grasp the math necessary to make an informed decision?
Further Reading
The below three-part series is where I drew most of my information:
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