You can’t eat IRR: On realistic performance expectations for private equity

More and more investors these days are becoming enthusiastic about investing in private equity. However, their interest in this asset class is often based on exaggerated return expectations of 20% and higher per annum. Due to inadequate knowledge and/or misguided marketing, apples (internal rates of return) frequently get mistakenly compared and equated with oranges (time-weighted returns). Those who know their way around the jungle of performance metrics are not only better informed, but are also likely to be disappointed less often by their private-market investments.

Good marketing or deception?

Private equity has steadily been gaining favor with investors in recent years. Although this asset class has not yet gone mainstream, it has long since broken out of its former niche role. Interest is mounting on both sides. Private equity managers view wealthy private clients as the next big growth market now that the potential among institutional investors has largely been exhausted. Individual private investors, in turn, want to partake in the vast universe of privately held companies to reap the highest possible returns amid low volatility.

Diversification has never harmed an investment portfolio, so individual private investors’ interest in investing in private equity is fundamentally a positive development. That interest becomes problematic, though, if it is based solely on lofty or even wildly overinflated return expectations, which can lead to misallocations or at least to big disappointments. This problem, unfortunately, is not purely of a theoretical nature. The image of private equity managers earning double-digit percent annual returns of 20% and above year after year is relatively widespread, not just among investors, but also in the financial press. But people not knowing better is not the sole cause of that distorted image. Another reason is the not infrequently deceptive reporting and the sometimes misguided marketing by private equity firms that exploit the complexity of this asset class for their own purposes and advantage.

“Less than 20% is boring” | High IRRs stoke false expectations

Private equity fund performance metrics*

*Data as of Q1 2014

Sources: Mantra Investment Partners, Pitchbook, Kaiser Partner Privatbank

Tricks employed by managers

Very high performance figures turn up in, among other places, the quarterly and annual reports of publicly traded private equity firms. US-based private equity giant KKR, for example, reports an internal rate of return (before fees), or IRR for short, of 25.5% for the years 1976 through 2023 and compares that with the much lower performance posted by the S&P 500 index (11.9%) and MSCI World index (9.2%) over the same period. As a standard practice, the specialized private-market financial data providers Pitchbook and Preqin also use IRRs in their statistics to measure the performance of private equity funds. By that metric, even a merely median fund of vintage 2014 earned an IRR of 19% over the last 10 years (see chart above), and private equity funds that invest in niches or specialize in specific single sectors even achieved a whopping IRR of 31% on average over that same period. Another metric, however, shows that no investors in reality are likely to have actually earned a 31% annual return on their invested capital and to have grown it by a factor of 15x (1.31¹⁰) with those top performers. That’s because the multiple on invested capital (MOIC) for the 2014 vintage amounts to a still substantial but much less spectacular 2.5x, which equates to a normal (time-weighted) return of 9.6% over 10 years.

The extreme example above demonstrates that private equity IRRs cannot be compared and equated with the time-weighted returns on liquid asset classes like stocks, bonds, or gold. That’s because, on one hand, IRRs always refer only to the specific share of capital actually invested in private equity but not to the usually larger part of it that has to be temporarily parked in a money-market account or invested elsewhere during the investment term. On the other hand, IRRs depend greatly on the timing of capital flows. Large early distributions particularly drive up IRRs (see table below). The timing of negative cash flows, i.e. investors’ payments into private equity funds, also has an impact. Private equity managers can create an optically large IRR by working with credit lines to delay calling capital from investors. A substantial share of managers regularly makes use of this possibility to tune (or better said, manipulate?) performance.

Not an ideal metric | IRRs are easy to manipulate

Influence of timing of capital distributions on IRR

Sources: L. Phalippou¹, Kaiser Partner Privatbank

The mathematical path to disillusion

(Capital-weighted) IRRs and time-weighted returns – just like proverbial apples and oranges – cannot simply be compared with each other. A closer look at the cost structure of private equity funds and the progression of a typical investment is helpful to gaining an understanding of why high IRRs of 20% and more erode considerably and leave a much smaller profit on the bottom line than one perhaps had been hoping for. Private equity has always been an expensive affair from an investor’s perspective, and the “democratization” of this asset class currently underway has done little thus far to change that. Private equity managers with a good track record continue to command annual management fees of 1.5%–2.5% and performance fees of 20%–25% today. Deducting those expenses turns a gross IRR of 23%, for example, into a net IRR of 17%.

From dreamlike IRRs… | …to the reality of time-weighted returns

Analysis of return erosion

Source: Kaiser Partner Privatbank

So far, so clear (and nothing out of the ordinary). But what’s even more interesting and less present in the minds of most investors is the second part of the analysis of return erosion. The typical progression of a conventional investment in a private equity fund envisages that the committed capital is called and invested over a period of four to six years. Only that capital actually locked in private-market assets yields a return at the net IRR cited above. In contrast, the capital not yet called and the money expected to be restituted to investors by the private equity fund after several years generate a much lower return equal to either the money-market interest rate (if the capital is parked in a money-market account) or the return on the broad equity market (if the capital is invested in a broad equity ETF), depending on an investor’s risk appetite. Typically, an average of only 35% to 40% of the committed capital in a private equity fund is actually invested in private market assets across the entire 10-year investment horizon. Therefore, in our example, the net IRR erodes further to 11.3% (in the case of investment in stocks) or to 8.8% (in the case of investment in a money-market account). The original gross IRR of 23% has thus decreased at least by half.

Once the gross IRR is corrected for fees and the capital allocation, only then do apples become oranges that can be compared with other liquid assets. The conversion table below shows what net IRRs are needed to earn equivalent time-weighted returns with an investment in a private equity fund. The difference is particularly striking if an investor is conservative and consistently leaves the uncalled committed capital in a money-market account. In that event, an IRR twice as high is needed to achieve the same capital growth after 10 years.

Apples and oranges | Capital-weighted return ≠ time-weighted return

Return comparison: Evergreen fund vs. traditional closed-end funds

Sources: StepStone, Kaiser Partner Privatbank

Our math exercise above is helpful in two respects. It not only puts the IRR metric into proper perspective, but at the same time illustrates why semi-liquid “evergreen funds” are arguably the better investment solution for most investors interested in private equity. Evergreens are always 85% to 90% invested in private-market assets, and they immediately reinvest the proceeds from successful exits. This means that the bulk of the capital benefits from the compound interest effect (and from high IRRs). Evergreen returns, too, admittedly get reduced because a cash allocation of 10% to 15% must be kept available at all times to service liquidity needs. But on the bottom line, good evergreen funds are at least on a par with the kinds of professionally run multimanager programs that only institutional investors like large pension funds, foundations, and insurance companies are capable of implementing.

Made for the compound interest effect | Evergreen funds are constantly (almost) fully invested

Portfolio allocation of an evergreen fund

Source: Kaiser Partner Privatbank

Realistic expectations

So, what returns are truly realistic with private equity? And are they also accessible to individual private investors via evergreen funds? Depending on the exact design of the investment vehicle, the specific allocation (e.g. venture/growth vs. buyout, or mega/large vs. mid-market), and the way in which the cash allocation is managed, managers of pure-play evergreen private equity funds normally aim for target returns ranging from 12% to 17%. A look at the London Stock Exchange shows that those numbers do not stir up unrealistic expectations. Since as early as the late 1980s, the LSE has been a listing venue for private equity investment trusts (e.g. Pantheon International since 1987, Hg Capital Trust since 1989) that operate on the evergreen principle and have delivered annual returns of 12% to 15% over a period of more than 30 years. The plausibility of those figures has been validated by a study by CEM Benchmarking,² which found that US pension funds earned an average annual performance of 12.4% with private equity during the period from 1998 through 2020. The excess return versus liquid equity markets over the 23 years observed amounted to 200 basis points over US large caps and 340 basis points over world stocks excluding the USA.

What’s realistic? | Good managers historically have earned a 12%-15% annual return

Performance of exchange-listed private equity investment trusts

Sources: Bloomberg, Kaiser Partner Privatbank

Brave new evergreen world?

In times of booming stock markets, annual returns of 11% or 12% may seem boring to many an investor. However, returns of that kind are actually higher than average in a long-term context. Since stock markets are still relatively highly valued despite this year’s correction and double-digit equity returns are unlikely again in the next five years, that’s precisely the reason why private equity is very attractive at the moment. In the past, the performance of this asset class has been especially high particularly during periods of flat or declining stock markets.

The most important chart | Private equity performs at the most crucial times

Average four-year excess return on private equity

Sources: Hamilton Lane (January 2024), Kaiser Partner Privatbank

Evergreen funds are the ideal vehicle to enable individual private investors to partake in the long-term outperformance potential of private equity and to diversify their portfolios by blending in this asset class. It is relatively easy to steer the target allocation with the aid of evergreens. Moreover, the capital is fully invested right from the outset and benefits from the compound interest effect. Furthermore, in contrast to traditional private equity funds with capital calls, with evergreens investors know right from the start in which (privately held) companies they are investing – there is no blind-pool risk. And whereas traditional funds are illiquid or are sellable on the secondary market only at a steep discount to their intrinsic net asset value, evergreen funds are semi-liquid. Investors normally can redeem their shares monthly or quarterly. However, redemption isn’t guaranteed because most managers reserve the right to limit the volume of share redemptions or to suspend them entirely during periods of financial-market stress. Generally speaking, private equity – evergreen funds included – remains an asset class for which investors should have a long time horizon of at least three years or, better yet, more than five years.

One other crucial point also mustn’t go unmentioned: apart from limited redemptions, private equity managers have the capital in open-end evergreen funds at their perennial disposal – hence the name “evergreen.” Whereas managers of traditional private equity funds have to liquidate their assets at as high a value as possible within a compressed time frame of three to six years, managers of evergreen funds are not under this compulsion. They earn their management fees solely on the basis of a fund’s invested capital volume and therefore may have an incentive not to cash in prematurely. Evergreen funds that are not spread widely across a variety of managers and numerous private equity deals but are instead highly concentrated under the management of a single private equity firm are particularly susceptible to this problem.

Even though it has become easier these days to gain access to the world of private equity, conducting rigorous due diligence when selecting managers remains just as important as making sure that a private equity portfolio has an optimal allocation. A do-it-yourself approach is likely to be the right way for only the fewest of individual private investors. One would be well advised to place trust in the expertise of a professional wealth management consultant.

¹ L. Phalippou (2024): “The tyranny of IRR”

² A.D. Beath, C. Flynn (2022): “Asset Allocation and Fund Performance of Defined Benefit Pension Funds in the United States, 1998-2020”