Allen Latta's Thoughts on Private Equity, Etc.
  • Allen's Blog
  • Blog Post Categories
  • Glossary of Private Equity Terms
  • Resources
  • About
  • Contact

LP Corner: Fund Performance Metrics - Internal Rate of Return (IRR) - Part Two

2/19/2018

1 Comment

 
This one of a series of posts on fund performance metrics.  Other posts in this series include:
  • LP Corner: Private Equity Fund Performance – An Overview
  • LP Corner: Fund Performance Metrics – Multiples TVPI, DPI and RVPI
  • LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part One
  • LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part Two - This blog post
  • LP Corner: Fund Performance Metrics – Public Market Equivalent (PME)
  • LP Corner: Fund Performance Metrics - Private Equity Fund Performance
  • LP Corner: Gross vs Net Returns

In this post, we will explore internal rate of return (IRR) as a tool for evaluating fund performance metrics.
 
Recap
In my prior post, we discussed the basics of IRR in a fund context.  In this post, we build on that to explore what happens year by year for that fund.
 
In Example 1 in the last post, we introduced a fund, where the LP paid $30 million to the fund in a capital call at time = 0 and received $80 million back from the fund (as distributions) at the end of year 5.  These simple cash flows yielded an IRR of 22% and a TVPI of 2.67x.
Picture
​

To read more, please click on "Read More" to the right below.
Here are some questions.  What happened to the fund in years 1 through 4?  How did the fund develop?  What was the $30 million investment worth at the end of year 1, year 2, etc.?  What were the IRRs like along the way?  What was TVPI along the way?

Let’s start by exploring what happened at time = 0.  The LP has entered into a limited partnership agreement for the fund, and committed to invest $30 million into the fund.  The fund made a capital call indicating that the entire $30 million is required by a date certain, which for our model, is time = 0.  Note that funds don’t call all committed capital at the beginning of the fund, and so our example isn’t realistic, but this assumption makes the example easier.  Therefore, at time = 0, the LP contributed $30 million to the fund.  This capital, combined with the capital received from other LPs, is used by the general partner (GP) of the fund to pay for management fee and expenses, and for making investments in portfolio companies.
 
End of Year 1.  Let’s now say that after one year, the fund has paid no distributions to LPs, and our LP receives a statement stating that the LP’s investment is now valued at $27 million.  The LP’s investment has lost value, which is expected in the early years of a private equity fund (and most particularly venture capital funds), and is known as the J-Curve.  For more on the J-Curve, see the post “LP Corner: The J-Curve.”
 
Example 1A shows what this looks like in a table:
Picture
​Table 1A above shows that the LP paid out $30 million at time = 0, and at the end of year 1, has received no distributions, but the LP’s investment value is $27 million (this is also known as Residual Value).  Since no distributions have been paid, Residual Value is the same as Total Value (Recall Total Value = Distributions + Residual Value).
 
Now recall that IRR is the return for a series of cash flows – cash flows out and in.  The calculation of IRR requires that there be at least one cash outflow and at least one cash inflow.  In our example, there is a cash outflow – the $30 million cash outflow for the capital call, but there is no cash inflow – there is no distribution back to the LP.  This leads to the critical assumption.
 
The Critical Assumption.  In order to calculate the IRR for Example 1A above, we assume (and this is a big assumption) that the LP’s investment value of $27 million at the end of year 1 is a cash flow back to the LP.  This is a critical point – we assume that the LP’s investment value of $27 million is a cash flow back to the LP.  This assumption is not reality – in our example, the reality is that the LP doesn’t get any cash back until the end of year 5.  This is why the calculated IRR before all cash is returned to the LP is known as “interim IRR.”  Interim returns present difficult issues when evaluating the performance of a fund.
 
Once we assume that the LP’s investment value of $27 million is a cash flow back to the LP, we can calculate the interim IRR, which is -10%.  We also make the same assumption to calculate the interim TVPI multiple, which is 0.9x.  Note if we calculated IRR or TVPI without making the assumption that the investment value is treated as a cash flow back to the LP, the interim IRR would be -100% and the interim TVPI would be 0.0x.  Thus, without making the assumption, the interim return metrics would not provide any useful information.
 
End of Year 2.  At the end of two years, there still have been no distributions to the LP, and the LP receives a statement showing that the LP’s investment value is now $30 million, up from $27 million at the end of year 1.  This increase reflects that the fund’s investments have started to improve.  The table 1B below shows this:
Picture
​Making the same assumption as before (that the LP investment value is treated as a cash flow back to the LP), provides an interim IRR of 0% and an interim TVPI multiple of 1.00x, reflecting the improvement in the fund’s investments.
 
End of Year 3.  At the end of three years, there still have been no distributions to the LP, and the LP receives a statement showing that the LP’s investment value is now $50 million, significantly up from $30 million one year prior.  This is due to the fund’s investments taking off in value.  This is shown in Example 1C below:
Picture
​Interim IRR at the end of year 3 is now 19%, up from 0%, and the interim TVPI multiple is 1.67x, up from 1.00x.  Nice improvement!
 
End of Year 4.  Same thing, next year.  At the end of year 4, there have been no distributions to the LP, and the LP receives a statement showing that the LP’s investment value is now $65 million.
Picture
​Interim IRR at the end of year 4 is 21% and the interim TVPI multiple is 2.17x.
 
End of Year 5.  At the end of year 5, the fund exits its investments and distributes $80 million to the LP.  The fund is liquidated and no longer exists.  This is now a final return to the LP.
Picture
​IRR Graph.  Now let’s look at how the IRR developed over time graphically.  As the graph below demonstrates, the LP experienced the J-Curve, with a negative interim net IRR in year 1, recovering and going positive in later years and leveling off in year 5.
Picture
 Take-Aways:
  • Gross vs net return.  We have examined the cash flows and returns from the perspective of the LP, so these are net returns.  Gross returns are the returns a fund obtains from its investments in portfolio companies, which do not deduct management fees, fund expenses, or carried interest.  Net returns to the LP do deduct management fees, fund expenses and carried interest.  The differential between gross and net returns can be substantial, and LPs ultimately care about net returns.
  • Interim vs final return.  All returns are interim until the fund has fully liquidated and no longer exists.  Once the fund has liquidated, the returns are final.  As can be seen from the example, the year 1 interim IRR of -10% is nothing near the final IRR of 22%.  However, the year 4 interim IRR of 21% is very close to the final IRR of 22%.  Interim returns early in the life of a fund (the first 3-4 years) are not good predictors of final IRRs.  However, interim returns late in the life of a fund (years 7 on), especially when there have been meaningful distributions, are better predictors of final fund performance.
  • Problems with Interim Returns.  The problem with interim returns is that a major assumption has been made – that the LP’s investment value in the fund at the calculation date is a cash flow to the LP.  This is a faulty assumption for two main reasons: (1) the LP’s investment value is determined by the GP based on assumptions of value for the fund’s investments, and these estimated values are rarely accurate; and (2) the LP’s investment value is an estimated value for its illiquid stake in the fund – if the stake were to be sold the LP would most likely sell its stake for less than the stated investment value, so the investment value likely overstates the true liquid value for its interest in the fund.  The bottom line is that LPs should take interim fund valuations and interim returns with a grain of salt.
 
Next up: using multiples and IRR to evaluate fund performance against similar funds.
1 Comment
Eduardo Reinaux
6/19/2020 05:21:51 am

Hi Allen!
I came accross your post when I wanted to confirm the idea of interim IRR. I am an analyst at a global direct and LP investor who got asked to calculate Net IRR. This blog post was useful to support my initial thoughts. Keep up the good work. Thank you!

Reply

Your comment will be posted after it is approved.


Leave a Reply.

    About this Blog

    This Blog is a collection of thoughts on a variety of topics of interest to me, including:
    • Private Equity
    • Buyouts
    • Growth Equity
    • Venture Capital
    • Corporate Finance
    • Investment Banking
    • IPOs
    • M&A
    • Technology
    • Economics
    • Law
    I hope you find this blog of interest.
    View my profile on LinkedIn

    Categories

    All
    Anti-Dilution
    Berlin
    Board Of Directors
    Brazil
    Buyouts
    California
    China
    Cleantech
    Corporate Finance
    Corporate Venture Capital
    Crowdfunding
    Dilution
    Dividend Recap
    Economics
    Emerging Managers
    Endowments
    Entrepreneurship
    Europe
    Fund Terms
    General
    Growth Equity
    Healthcare
    India
    Innovation
    Investment Banking
    Ipo
    Israel
    Law
    Legal
    Libor
    Life Sciences
    Listed Private Equity
    London
    Los Angeles
    LP Corner
    M&A
    Mexico
    New York
    Pensions
    Politics
    Private Equity
    Public Stocks
    San Francisco
    Secondaries
    Secondary Exchanges
    Silicon Valley
    South America
    Speaking
    Stock Market
    Stock Options
    Tax
    Technology
    Travel
    United Kingdom
    Valuation
    Venture Capital
    Venture Capital Deal Terms
    Webinars


    Archives

    October 2021
    August 2021
    July 2021
    April 2021
    March 2021
    February 2021
    January 2021
    December 2020
    November 2020
    October 2020
    September 2020
    August 2020
    July 2020
    June 2020
    May 2020
    April 2020
    February 2020
    December 2019
    November 2019
    October 2019
    September 2019
    August 2019
    July 2019
    June 2019
    April 2019
    March 2019
    February 2019
    January 2019
    December 2018
    November 2018
    October 2018
    September 2018
    August 2018
    July 2018
    June 2018
    May 2018
    April 2018
    March 2018
    February 2018
    January 2018
    December 2017
    November 2017
    October 2017
    September 2017
    August 2017
    July 2017
    June 2017
    May 2017
    April 2017
    March 2017
    February 2017
    January 2017
    December 2016
    October 2016
    September 2016
    August 2016
    July 2016
    June 2016
    May 2016
    April 2016
    February 2016
    January 2016
    November 2015
    October 2015
    July 2015
    June 2015
    May 2015
    April 2015
    March 2015
    February 2015
    January 2015
    December 2014
    November 2014
    October 2014
    September 2014
    August 2014
    July 2014
    June 2014
    May 2014
    April 2014
    March 2014
    February 2014
    January 2014
    November 2013
    October 2013
    September 2013
    August 2013
    July 2013
    June 2013
    May 2013
    April 2013
    February 2013
    January 2013
    December 2012
    November 2012
    October 2012
    September 2012
    August 2012
    July 2012
    June 2012
    May 2012
    April 2012
    March 2012
    February 2012
    January 2012
    December 2011
    November 2011
    October 2011


    Copyright Notice:

    ​All original works on this site are 
    © 2011-2020 Allen J. Latta. All rights reserved.  Neither this website nor any portion thereof may be reproduced or used in any manner whatsoever
    without the express prior written permission of Allen J. Latta.

    LP Corner® is a registered trademark of Campton Private Equity Advisors.  Used with permission.

    DISCLAIMER:  Readers of this Blog are not to construe it as investment, legal, accounting or tax advice, and it is not intended to provide the basis for the evaluation of any investment.  Readers should consult with their own investment, legal, accounting, tax and other advisors to the determine the benefits and risks of any investment.

    Private equity investments involve significant risks, including the loss of the entire investment.

    This Blog does not constitute an offer to sell or the solicitation of an offer to buy any security.

Copyright © Allen J. Latta.  All rights reserved.