Be gone, IRRs! Come June, limited partners will demand a new “cash-in and cash-out” standard for measuring returns on private equity funds.
“IRRs [internal rates of return] are meaningless,” said Richard Hayes, chairman of the newly incorporated Institutional Limited Partners Association (ILPA) and senior investment officer for the California Public Employees’ Retirement System’s (CalPERS) alternative investment program. “Although IRRs are an indication of how a fund is doing in the interim, at the end of the day, if I give you $1, what we care about is that we get $3 back, and when. Unless we get our principal back and cash profits, there’s nothing.”
Hayes revealed the ILPA’s proposal late last month at CalPERS’ investment committee meeting in Sacramento. “From an LP’s standpoint, cash-in and cash-out is what really matters because cash pays the benefits and helps retirees,” he said.
IRRs, said Hayes, are inconsistent and misleading. Since IRRs are based on valuations of privately held companies, two funds can calculate different valuations – and different IRRs – for the same investment. A cash-in and cash-out reporting standard could eliminate those inconsistencies with a simple and transparent method of calculating returns.
“In the venture business, there are some standard ways to report an increase in valuation, i.e., to carry the investment at its value in the most recent round of funding,” said Lindsay Jones, a Boston-based partner with Advent International. “But when there’s a decrease in valuation – what we’re seeing a lot of these days – whether the venture firms are taking reserves against troubled investments in the same way, or how they’re valuing those investments, there’s no real standard.”
Moment Of Reckoning
In a rocky period for GP and LP relations – when VCs are slashing management fees and personnel in order to cut costs and returning capital to their investors – the ILPA’s proposal may be the group’s first move in an effort to force GPs to atone for the sunk investments of the late 1990s.
“LPs are our customers, so they get to determine our performance standards,” said Micah Avni, a partner with Jerusalem Global Ventures (JGV) in Israel. “This is fair enough. On a personal level, I prefer more transparency. The good guys only stand to benefit from this.”
According to the ILPA’s proposal, invested cash would be measured against what is returned to the LP in the form of liquid stock on the day the stock is distributed to LPs. Basically, it’s a vintage-year approach that will look at funds in the years six through 10 – once the investment capital has been deployed and cash and profits already are being distributed – and then compare the returns of a given fund with its peers.
“It would be a lot easier on the LPs that have hundreds of funds to look at if there was a single benchmark everyone used,” said one California-based institutional investor. “We want to get GPs on the same formula so there’s less opportunity to manipulate returns.”
Still, while the ILPA’s proposal may standardize how investments are valued, it will not eliminate the industry’s reliance on IRRs as a performance measurement standard before a fund matures and for first-time funds.
“Initial investments are based on the team and their personal track records, and to a lesser extent, focus, strategy and proprietary deal flow. But how will LPs make decisions about Fund II and Fund III, which are still too young to be measured on a cash-in and cash-out basis?’ asks JGV’s Avni. “In these cases, it probably makes sense to stick with IRRs but adopt an industry standard for calculating them.”
Venture Economics already calculates a distribution to paid-in ratio and includes the standard in its fund performance reports to LPs. Cambridge Associates of Boston also calculates the cash-in and cash-out standard for LPs.
CalPERS investment committee members William Crist and Robert Carlson voiced immediate support for the ILPA’s proposal. Hayes will come back to the investment committee with the group’s formal recommendations in June.
For his part, Hayes has been among the most vocal and forceful in demanding transparency in the private equity industry. Since taking over as head of CalPERS’ $20 billion private equity program in July following Barry Gonders’ departure, Hayes has posted fund performance reports on the pension fund’s Web site and has taken on the chairmanship of the ILPA as a means of organizing LPs and promoting research and standards throughout the private equity industry. This month, he distributed a list of capital calls to CalPERS’ investment committee along with his group’s monthly performance report. Hayes said he plans to add distribution reports to the list over the coming months.
The ILPA represents more than 100 organizations worldwide and 80% of its members hold assets greater than $5 billion. Two-thirds of all institutional private equity investors are members of the group.