Internal Rate of Return ("IRR")

Infernal Fact to Disclose

Sometimes referred to as a "dollar-weighted return," an IRR is arguably the single best estimate of the rate of appreciation produced by money placed in the hands of a private investment manager. Mind you, we did not say money committed to a private equity manager. Whereas committed capital comprises two parts � the money a manager has "called" from clients plus further sums that clients have pledged to invest � the asset base on which IRRs are computed comprises only funds actually placed in the managers' hands. What, then, does an IRR tell you? It tells you the annualized percentage change in this asset base after adjusting for external cash flows (i.e., capital contributions or withdrawals). The reason that the resulting figure can be infernal is that it sometimes reveals a large gap between the returns produced by the investments a PI firm has made and the returns actually realized by its clients.

Sad but True

Making our way merrily through a stack of perhaps a million proposals from prospective PI managers, your staff reviewed recently two documents that highlight how dramatically timing adjustments affect IRR calculations. One PI firm reported a 36% IRR on its second fund, which drew capital from limited partners in two equal tranches on predetermined dates. Accordingly, the fund held large dollops of cash for extended periods. For curiosity's sake, we computed what the IRR would have been if the firm had made "institutional drawdowns": capital calls on 10-15 days' notice, timed to coincide with actual investment opportunities. The IRR would have been 47%. In other words, the manager has proven highly skilled at picking good businesses in which to invest, but relatively unskilled at managing its own affairs. In the second example, the manager drew down 100% of the fund's capital at its initial closing. The resulting cash drag has reduced the fund's IRR by 1000 basis points per annum (17% vs. 27%). Ouch.