Private Equity Performance Numbers May Undermine Credibility

Internal rate of return (IRR), the key performance measure of private equity firms, is at the risk of being “massaged in a way that undermines the industry’s credibility and adds dangers when a downturn comes,” according to a recent article in The Wall Street Journal.

The IRR, the article explains, is based on a complex set of numbers tied to fund cash flows but the increased use of bridge financing by firms (borrowing money to make investments instead of immediately using investor cash) is “flattering the IRR figures some funds report.” Such borrowing effectively “shortens the time during which investors’ cash is actually in the fund. When you shorten the apparent time it takes to generate a cash profit, that boosts the IRR—sometimes in a very big way.”

While there may not be an incentive for fund managers and investors to shine a light on this issue (after all, IRR is a key determinant in how and when they get paid, the article says), some are “growing more worried about the damage that might be done by this borrowing.” Specifically, the article underscores the risk that funds will face if the markets take a turn, “banks withdraw the financing and some investors can’t deliver their fund commitments, even after their money has in effect already been spent.”