Editor’s Letter: Warren Buffett questions legitimacy of PE’s use of IRR

Warren Buffett has long been a critic of private equity, and he was at it again this month at Berkshire Hathaway’s annual meeting, according to Bloomberg.

Buffett questioned private equity’s performance calculations and cast doubt on the legitimacy of using internal rate of return as a measure of performance. He argued that firms will include uncalled capital that LPs lodge in Treasury bills when charging management fees, but exclude that when calculating IRR.

It makes their return look better if you sit there a long time in Treasury bills, Buffett said, according to the Bloomberg report. It’s not as good as it looks.

Buffett warned pension funds to be careful when assessing fund proposals from PE managers. We have seen a number of proposals from private equity funds where the returns are really not calculated in a manner that I would regard as honest, he said, according to Bloomberg.

Smoke: IRR has come under scrutiny in recent years as a not-fool-proof method of gauging a manager’s performance. It’s even trickier these days with the rise of the use of credit facilities to delay a GP calling capital from investors for up to a year. Use of such credit can boost a fund’s performance by up to 300 or even 500 basis points, I’ve heard anecdotally from sources. This can help get a GP over its performance hurdle and make it eligible to start collecting carried interest.

This type of performance gaming is rendering IRR even less reliable as a true measurement of a manager’s strength. A common anecdote from investors today involves tracking funds that in their first year are producing eye-popping IRRs in the 40 percent range with multiples near par.

Howard Marks, co-chairman of Oaktree Capital Group, sounded the IRR warning way back in 2006 with his genre-setting memo, You can’t eat IRR: A high internal rate of return does not in and of itself put money in one’s pocket. Only when it’s applied to a material amount of invested capital for a significant period of time does IRR produce wealth, Marks wrote.

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 judgement. But there is no alternative. Reliance on a single figure can’t possibly provide the answer — not even IRR, Marks wrote.

Many LPs use a mix of IRR along with other performance measures to judge a manager’s performance. They look at public-market equivalents, and multiples like TVPI (total value to paid-in), to get a fuller view of performance. LPs these days do deep dives into the performance of each portfolio company and how that lends to full-fund performance.

Anybody sophisticated on our side of the business [the LP side] is looking at multiples for young funds, and down at the deal level. The returns of all the deals that make up the fund, looking at IRRs based on real cash flows, an insurance company LP told me recently. You have to ask for levered and unlevered cash flows of a fund when doing due diligence so you can recreate the IRR for what it is.