Fooled by IRRs (Yale, Schwarzman’s Cases)

“Everyone loves an optical illusion, except when it comes to financial results (1)”. Yet the private markets are not immune from optical illusion risks.

In the Yale Endowment 2013 financial report, the closing statement of the private equity commentary (2) states: “Since inception in 1973, the private equity program has earned an astounding 29,9 percent per annum.”

In the language of all other (non-private markets) asset classes, this would mean that USD 1 million invested on Jan. 1st 1973 would have become after 41 years, on Dec. 31st 2013, USD 45,49 billion. Not quite the reality. In fact, at the same date, the whole Yale endowment was “only” worth USD 20,78 billion.

In an interview with Bloomberg Television at the Milken Institute Global Conference in Beverly Hills, California, Mr. Schwarzman, Blackstone’s head, said “The stuff we do, the alternative class, tends to make around 1.000 basis points more than the stock market”.

What Mr Schwarzman says is that the average premium made by his funds against investments in the public markets is 10 percent. A premium of 10 percent implies that, in 10 years, if public markets produce a return of 8% more than doubling (2,16x) the initial investment, the private markets multiply the initial investment by more than five times (5,23x).

Having analysed the data of the substantial amount of buyout funds in the databases available publicly, I can say that I have encountered a few funds with such performance characteristics, but have found no evidence that the alternative class makes on average 10 percent more of the public markets.

The issue is in the “fooling” performance calculation convention.

In the case of Yale, 29,9 percent has to be assumed to be an internal rate of return (IRR) even if it is not stated. But, if this is the case, the stated percentage return should not be given the per annum suffix that instead denotes time-weighted returns (i.e. compound annual growth rates – CAGR).

In the case of Mr. Schwarzman, not only he seems to refer to IRRs but also he seems to compare the IRRs of his funds to the returns/CAGRs of the public markets. He might alternatively refer to PME analyses.

Abundant academic literature demonstrates that IRR should not be used in compounding and benchmarking, in particular against non homogeneous data, because of the continuously changing amount of capital at work and the related reinvestment risk. The IRR-derived PME measures that may have been also used have similar issues discussed in an earlier post.

The IRR approach implies (unrealistically) that the distributions of cash that are generated through the divestitures in private markets’ funds are immediately reinvested at the same rates of return that produced them. Good returns produce artificial performance numbers that look even better.

The private markets have so much potential and interesting characteristics (together with specific complexities) that communication should evolve to create more realistic expectations of their risk-return profile, in particular if they want to attract and not disappoint retail money.

It is helpful to take a fresher look from a different, more realistic perspective putting private markets’ valuations in a relative value framework coherent with the public markets.

Otherwise, when told about performance, always ask to know unit of measure and duration….

(1) Freely sourced from the capital markets practice brochure of a law firm totally unrelated to XTAL. Please get in touch for more info.
(2) Page 12


4 thoughts on “Fooled by IRRs (Yale, Schwarzman’s Cases)

  1. Matt July 29, 2014 / 8:10 am

    Great post. What do you think of:

    1. The aggregate reported returns from Yale for the entire endowment and the methodology behind this? To my understanding, the overall portfolio is reported as a time weighted series, calculated with essentially a daily IRR?

    2. Benchmarking PE IRRs against a benchmark IRR (so its apples for apples) when the purpose is not to compare to other asset classes?

    • mxsk1 August 17, 2014 / 8:33 pm

      Thanks for your comments Matthew.
      To your points:
      1. I am not sure how Yale reports performances. I inferred from numerical evidences that Yale’s private equity performance had to be in IRR terms. In general, I am surprised about the lack of specific information on the matter. I believe the overall PE portfolio performance was calculated by pooling cash flows and NAVs and measuring annualised IRRs.
      2. The academic version of the answer (Damodaran et al.) is that IRRs should not be used to rank investments, therefore not even IRR vs IRR is an apples for apples comparison. For subjective (because of the discretionarily chosen discount rate) benchmarking, NPV is the way to go. My practitioner explanation builds again upon the reinvestment rate issue. Early pay-outs shorten duration, enhance IRR but, in corporate finance terms, yield cash returns rather than (supposedly higher) ROIs – that is what is usually defined reinvestment risk. Here GPs would usually counter that cash goes to other investments – true, if the next investment is a good one and if it is available for an immediate lump-sum cash injection (that is never the case). And this opens to the other argument dear to GPs, the over commitment – that would deserve a longer philosophical discussion left for another occasion … But neither leverage (over commitment) nor an eventual reinvestment opportunity (implicit in the IRR case) assumptions should bias performance measurement.

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