IRR: Snake Oil by Another Name

Abstract

Finance uses the phrase “risk-adjusted returns” to define what value is, and fiduciaries are legally bound to consider both risk and reward in investment decision-making. This requirement is codified in the Uniform Prudent Investor Act, which states, “The trade-off in all investing between risk and return is identified as the fiduciary’s central consideration.” Yet, the most prominent performance metric in private equity (PE) is the internal rate of return (IRR), an inadequate tool for fiduciary purposes because it includes no concept of risk, which represents fully half of the characteristics that fiduciaries are obligated to evaluate. An astute fund manager can exploit this willingness of PE investors to pay for returns that are not creating positive alpha. The key to understanding how a manager can do this lies in examining the role that financial leverage plays in the returns of PE funds and how such financial leverage affects IRRs. Metrics built on the direct alpha public market equivalent (PME) analysis are appropriate to estimate the risk-adjusted returns generated by PE funds and to fulfill fiduciary duties.

TOPICS: Private equity, fundamental equity analysis, factor-based models, equity portfolio management

Key Findings

• • The IRR metric is wholly inadequate to perform the function of a fiduciary because it has no concept of risk, which constitutes fully half of the characteristics that fiduciaries are obligated to evaluate.

• • An astute fund manager can exploit the willingness of PE investors to pay for returns that are not creating positive alphas.

• • Metrics built on the direct alpha PME analysis are most appropriate to capture the risk and return characteristics that fiduciaries are legally required to consider.