You can’t live on IRR, even in 2024. Or can you?
Of course not! We borrowed the famous title of Howard Marks’ memo, which has become something of a classic in the private equity (PE) world. His 2006 memo captures the issue perfectly and is definitely worth revisiting.
e originally wanted to create a similar step-by-step example to illustrate how IRR behaves in relation to other performance metrics, but instead we would rather refer you directly to this memo. It is remarkable how relevant an 18-year-old piece remains almost a generation later. Perhaps even more so today, as we tend to forget some of the fundamentals on which PE operates.
Making a lot of money with the risks under control isn’t easy. It’s not even easy to identify the best performing managers. Not only is the quantification of returns themselves subject to debate, but it’s often far from obvious whose risk-adjusted-returns are the best. All performance assessment demands quantitative ability tempered by judgment. But there is no alternative. Reliance on a single figure can’t possibly provide the answer – not even IRR. Howard Marks, 2006
How did we even get here? In recent years, from 2020 to 2024, opportunities to invest in PE and VC have been popping up all over the Czech Republic. Many people wave them around as proof that they have access to the latest “in” thing.
Paradoxically, however, we believe PE is entering a difficult period. It will take time for the full impact of the changing environment to become visible after more than two decades in which very different conditions prevailed. We are already seeing signs of this: fewer IPO exits, more zombie funds, problems with distributions, and at the same time a growing number of new solutions designed to get at least some cash back to LPs.
Because I, Oldřich Myslivec, had the opportunity to spend several years at CVC Capital Partners, one of the world’s largest and most successful PE firms, I decided to write an article summarizing some of my thoughts on the subject. At Family Office Partners, PE is naturally one of the asset classes we focus on as part of our Endowment Model. We also feel a certain responsibility to contribute to better education around these topics in the Czech Republic.
Everyone knows they should not rely solely on IRR to calculate and compare investment performance. And yet, they do it anyway.
People who truly understand the field use other metrics as well. Paradoxically, even in the professional, let us say institutional, world, there are not that many of them. It is difficult to say whether this is primarily the result of marketing and sales pressure or simply a reluctance to dig deeper.
After so many years of falling interest rates and rising valuations, perhaps that is understandable. The earlier emphasis on operational efficiency and excellence, which helped drive increases in company value, has increasingly been replaced by a game of numbers and Excel spreadsheets. And that applies to far more than finance and investing.
You simply cannot do without DPI, TVPI, and other metrics if you care about how much you will actually get back from an investment.
What is particularly striking is that throughout roughly 40 years of enormous growth in private equity, IRR has remained remarkably dominant in the way performance is presented. Even more surprisingly, relatively few investors challenge those numbers loudly or systematically.
At some large firms, historical IRRs have become part of the marketing. Unfortunately, the figures being presented may relate to older funds and can represent a selective choice designed to make a stronger case against competitors. Paradoxically, older funds can look particularly attractive when presented through IRR compared with newer competitors.
Few can promise you as much as a PE fund or its distributor.
Some pension funds even use IRR as part of the basis for employee bonuses, creating a potential conflict of interest when the metric itself may not reflect the ultimate economic outcome for investors.
Perhaps even more strikingly, GP carried interest and hurdle rates can also be linked to IRR.
More recently, the conditions in PE and the consequences of limited information for investors have also been addressed by a US court. Private markets do not operate under the same disclosure framework as public markets. The SEC’s attempt to introduce additional requirements through the Private Fund Advisers Rule was ultimately unsuccessful.
Ironically, the push for change came from existing LPs seeking to address “a lack of transparency, conflicts of interest, and a lack of effective internal governance mechanisms to protect capital managed by private funds.” But when the investors are qualified investors, the PE industry’s response can effectively be: “Feel free to go elsewhere.”
Now, however, it is important to look at the other, more positive side of the argument.
Even though everything mentioned above is far from perfect, PE still belongs in a portfolio. Why? We feel it makes us better investors. It forces us to try harder.
First, we do our homework in the form of thorough due diligence. Then we invest and give the investment enough time to see whether it succeeds or not.
We actually see the fact that it is not marked to market (MTM) as a positive. Of course, we know that underlying volatility still exists. It is obvious that MTM valuations could be wild as financing conditions, valuation multiples, and other parameters change over time.
Still, we believe that if you go deep, do 100% of the work you reasonably can to verify an investment, and execute it accordingly, then at the time of making the decision it can still be the “right investment,” regardless of whether the ultimate outcome turns out to be positive or negative.
That is simply part of the process, and we consider the process extremely important. This approach then carries over into many other aspects of investment life, not just within a multi-family office.
With large funds, however, the investment can become more of a black box. The amounts involved are so large that you naturally begin to wonder whether everything is really under control. Who will you sell it to? What is the exit strategy? Will it be sold to another fund managed by the same firm? Will money be borrowed to make distributions to LPs? Will the investment simply be held for longer? Or will it be sold into the rapidly growing secondary market?
In our view, any investment where you can go deep, verify how things actually work, and speak directly with the people who execute the strategy and have genuine expertise gives you at least a basic level of confidence in what you own.
You understand what is in your portfolio. And you understand its strengths and weaknesses.
It is encouraging that we have funds like this in the Czech Republic, even if there are relatively few of them, and naturally there are many more abroad. But finding them requires diligence, deep knowledge, and a willingness to dig through the details.
The dispersion of results between funds is enormous, as the table below illustrates. That is why some investors will tell you there is nothing better than PE, while others would rather not discuss the PE managers they selected at all.
Few people stay in the market long enough to actually see the final results of the vintages they personally invested in or recommended for a portfolio.
Family offices may be an exception. They tend to have lower turnover, which creates at least some degree of ownership over decisions made years earlier. In the commercial world, that continuity is often missing. We see this as a major difference in the multi-family office approach: ownership of the investment decision.
The following table provides perhaps the most interesting overview of results across individual funds and vintages, including both TVPI and IRR. Total carry is included simply to illustrate where the strongest economic incentives for fund managers lie, and they certainly do not come only from management fees.
Before we wrap up, let us also look at PE results within US pension systems. It would be difficult to accuse these institutions of lacking expertise. Yet the results of some of the biggest PE names are surprisingly weak, while a number of smaller PE funds have generated interesting returns.
Large private equity funds
And now for the big fund names and their actual results...
KKR
We will add one interesting point from KKR’s 10-K reporting, just to give you something to think about. It is hardly surprising that so many different numbers are circulating when it is not always obvious how they were calculated in the first place.
Much that once was is lost, for none now live who remember it. Galadriel
The key figure here is Net MoM (Multiple of Money). That is the economic reality for LPs. We will leave the remarkably consistent IRR without further comment.
Blackstone
Carlyle
And finally, our "favorite" CVC
So, what should we take away from all this?
- It is interesting to look at funds that have overstayed their welcome. They are already beyond the 10+2-year mark and still have NAV, or remaining value, in the portfolio. These funds now have to decide what comes next.
- Another important point is that the same IRR does not necessarily correspond to the same investment multiple. That is a fundamental difference.
- A useful mental exercise is to take individual MOICs (Multiple on Invested Capital) and translate them into an annualized return over the entire life of the fund, for example ten years. Oops...
The result is a mixed picture that makes one thing clear: finding the right combination of funds, fund sizes, investment edge, and team specialization is just as difficult as any other part of long-term investing. And it is difficult not only to identify these funds, but also to gain access to them in the first place. Good small and mid-sized funds understand the limits of their own size if they want to execute their strategy successfully. Large funds do not have the same concern. It is a completely different game.
Private equity within endowments
Because we run a multi-family office and draw inspiration from the Endowment Model, it is also worth looking at how Yale’s endowment has approached the presentation of PE performance.
Until 2013, Yale reported IRR in its annual reports. From 2015 onward, following criticism of mixing different measures of performance, it began reporting annualized returns instead. Venture capital still looks wild, of course, but that is hardly surprising. Early investments in exceptional founders and young funds are precisely where these opportunities can arise.
Private equity at Family Office Partners
We are very cautious about where we invest our own money, and we know that other families at Family Office Partners feel the same way. An investment based on incomplete information should not suddenly become convincing just because it comes with a beautiful double-digit IRR.
- Have you ever thought more deeply about what PE and VC actually do and how they do it?
- Have you compared them with other assets, not only in terms of returns, but also in terms of their behavior and characteristics, which may not always be purely financial?
- How do you view the Czech market and the institutions or individuals offering similar investments?
We have a sneaking suspicion that next time we may be writing a similar article about ALTs, or alternative investments. We used to call them AI, but that abbreviation has become rather inconvenient these days. They may be next in line.
If you have made it this far, you have our full respect. Below you will find some further reading that we highly recommend.
Explanation of abbreviations used:
IRR (Internal Rate of Return): The annualized discount rate at which the net present value of an investment’s cash flows equals zero. In practical terms, IRR reflects both the size and timing of cash flows. But a higher IRR does not necessarily mean a higher total profit.
MOIC (Multiple on Invested Capital): How many times the original investment has grown. For example, if an investment of $1 million ultimately produces $2 million in total value, the MOIC is 2x.
MoM (Multiple of Money): Broadly the same concept as MOIC. A MoM of 3x means that every $1 invested has generated $3 in total value.
TVPI (Total Value to Paid-In): The total value of an investment relative to the capital contributed, combining both distributions already received and the remaining value of the investment.
DPI (Distributed to Paid-In): The amount of capital actually distributed back to investors relative to the amount they contributed. Unlike TVPI, it reflects realized cash distributions rather than remaining portfolio value.
Recommended reading, tables used, articles, whitepapers:
Oaktree, Howard Marks: You Can’t Eat IRR - https://www.oaktreecapital.com/docs/default-source/memos/2006-07-12-you-cant-eat-irr.pdf
The parallel universe of private equity returns - https://www.ft.com/content/33ec23c0-fe95-44ec-a173-bd2fb9b66e63
An Inconvenient Fact: Private Equity Returns & The Billionaire Factory - https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3623820
The Trillion Dollar Bonus of Private Capital Fund Managers (June 12, 2024) -https://ssrn.com/abstract=4860083
Pensions Piled Into Private Equity. Now They Can’t Get Out - https://www.wsj.com/finance/investing/pensions-piled-into-private-equity-now-they-cant-get-out-d3ca796d
Private Equity: Fooling Some of the People All of the Time? - https://blogs.cfainstitute.org/investor/2020/01/20/private-equity-fooling-some-of-the-people-all-of-the-time/
IRR is an Easily Manipulated “Performance” Metric - https://www.reit.com/news/blog/market-commentary/irr-is-an-easily-manipulated-performance-metric