The Baloney of IRR’s

This short note has been prompted by somewhat recent solicitations of our capital.  Or perhaps it’s aimed more directly at one venture capital firm – rather a firm that thinks they are venture capitalists because they happen to have access to capital.  They also have an IRR or two that looks impressive which gives them marketing materials.

Investment managers, and specifically private equity or venture capital, usually need solid historical returns to gather assets.  Clients usually won’t flock to a manager that has no historical returns or one that has a record of lousy historical returns.  This seems obvious and although it may not always hold true near the end of a cycle (when suppliers of capital are feeling the fear of missing out and we’re in an environment where anyone can raise money), it’s generally accurate.  Managers know this historical record requirement generally exists and so when dealing with prospective clients they show them past returns.  Prospective clients are usually given some sort of deck or pitchbook telling about the firm, the firm’s most successful investment(s), and often displaying some derivative of historical returns.  I’m consistently amazed at how tricky these pitchbooks often turn out to be.

One way venture capital and even traditional equity managers pitch their returns is on IRR’s expressed as a percentage.  So they may say that their latest fund had an IRR of 25%.  Sounds good, right?  Though nowhere in these pitchbooks is IRR explained or defined beyond its literal meaning of “internal rate of return”.    A high IRR is certainly desirable, but it says almost nothing unless you know what percentage of the capital under their management that was deployed and how long the fund held onto that capital.

Let’s presume that as a venture capitalist I run a fund that has $100 million.  I invest $1 million in something, then sell that something one month later for $2 million.  That doubling will annualize to an IRR of about 400,000%.  And if that’s the only investment my fund made, that is also the funds IRR!  Going further, let’s presume Frank was one of my investors and he committed $10 million to the fund.  With the above example, Frank will get back $10.1 million – or a 1% return.  I doubt Frank is dancing on the table due to his 1% return despite the funds reported IRR.  This is an extreme example, but it shows the misleading nature of IRR’s.  One fund with a higher IRR didn’t necessarily outperform another and if it is presenting IRR’s as the sole evidence of outperformance, it’s simply cherry picking and hoping for naivety in its prospective investor.

IRR’s are useful because as a venture fund sells assets and distributes proceeds or raises additional funds there needs to be a yardstick that measures the returns of funds expanding and contracting.  Time-weighted returns simply don’t work well in that regard.  Also, IRR’s do show how good a fund did with the capital it employed, but tells you nothing about how quickly and for how long it put the money to work.  In funds that have lockups and are illiquid (every VC and PE fund), you care deeply about the quick and long.

Returns mesmerize and stupidify people, even very smart people.  There is no one metric in a pitchbook that will or should judge a funds performance or its suitability for investment.  It’s a complex multi-faceted analysis.

A couple more things to consider.  As I’ve written, IRR’s don’t tell you how much or for how long.  They also don’t tell you the times-capital-returned (how much did you get back vs your original investment) and they don’t consider how much risk a fund took to earn its return.  Private equity funds like to tout their risk-adjusted returns which are derived from and incorporate volatility over some given time frame.  Private equity is nothing but a levered bet on the stock market.  In the huge majority of cases, volatility is MUCH higher in private equity funds – it’s only reported as lower because the general partner (GP) gets to peg the values of the portfolio companies at any given time, not the market.  Imagine that!

When a fund tells you its IRR or an IRR on an investment, think hard about what it’s actually telling you.  No single figure can provide the answer for true risk-adjusted total returns.



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