Private Eye: Capital-call loans make IRRs even more cryptic

Chalk up one more reason that internal rates of return can be misleading — and one more reason that the industry needs to emphasize that they are not equivalent to compound annual growth rates.

With interest rates low, growing numbers of buyout firms use capital-call bridging facilities to cover the equity portions of their deals in the early months. Sometimes the loans cover the debt portions, too. Buyout firms keep the loans in place for six months to a year before replacing them with cash drawn from investors and, in some cases, permanent debt. A typical interest rate is Libor plus 175 to 300 basis points — dirt cheap.

Capital-call loans have big advantages. For one, buyout shops enjoy a bump in IRR from not drawing down investor capital right away.

Oliver Gottschalg, an associate professor at HEC Paris and an entrepreneur whose company offers benchmarking tools, analyzed a pool of 149 funds vintage years 2003 to 2006.  He found a median uplift of 58 bps on fund IRR when the funds used a capital-call loan of as long as a year from the first capital call. Capital-call loans also eliminate the risk that after broken deals, sponsors get stuck with drawn-down capital but no place to put it.

LPs like the loans because they can better anticipate the timing of capital calls. Many buyout shops even promise investors that they won’t make their first capital calls until the end of the first year. After that they may call capital quarterly or semiannually.

Hugely popular

To be sure, buyout firms using the loans to bridge permanent debt risk over-equitizing their companies. And some limited partners might find it distasteful that GPs can meet their hurdle rates of return sooner. But with GPs and LPs by and large on the same page, capital-call loans have exploded in popularity.

Scott Case, group head of global private equity services at Silicon Valley Bank, told me that the firm has $6 billion in funded capital-call loans outstanding and a team of 80 people working on the business. He estimates that 70 percent to 75 percent of mid-market buyout funds under $2 billion in size, and an even higher percentage of larger funds, have used them to some degree.

Here’s the problem. Capital-call loans don’t fundamentally alter the return on a deal. If anything, the investment multiple suffers slightly because of the fees and interest paid on the loan. Industry professionals understand that IRRs can be massaged in this way. They understand the other flaws of IRRs: that they can be heavily influenced by early wins and losses, and that they are based in part on valuation estimates supplied by the buyout shops, which benefit from higher IRRs.

The public is not familiar with these flaws. And the industry is not doing a good enough job of making the distinction between IRRs — a calculation that takes into account the lumpiness of private equity cash flows — and the time-weighted compound annual growth rates, commonly referred to as annual returns, used to measure public equity performance.

Consider the widely quoted figure that appears in a year 2000 prospectus for a Bain Capital feeder fund created by Deutsche Banc Alex. Brown:

The prospectus trumpets that Bain Capital achieved an “average annualized rate of return” of 88 percent for its first five funds from 1984 to 1999. A thorough reading makes clear the figure is an IRR gross of fees. But that hasn’t stopped the Washington Post, New York Times and Reuters news service from repeating the top-line number with no further explanation. (An 88 percent annual return over 16 years generates a 24,351x investment multiple.)

No direct comparison

Less pardonable is an April 12 press release from the American Investment Council, until recently known as the Private Equity Growth Capital Council, titled “Private equity returns far exceed declining market returns on multiple time horizons.”

In it the council shows how the median of several private equity benchmarks based on time-horizon IRRs beat public markets over one-year, three-year, five-year and 10-year periods. The IRRs are simply referred to as annualized returns. (The report on which the release is based makes clear that the private equity benchmarks are based on time-horizon IRRs.)

A source at AIC agreed that IRRs are not directly comparable to annual returns. But this person said that adopting unfamiliar financial terms might sow confusion with the legislators and staffers that are the council’s main audience. The council’s hands are tied because it relies on third-party benchmarks, the source added. The council would be open to using a more comparable metric if the industry agreed to one.

Even benchmark provider Cambridge Associates, creator of performance indices based on pooled time-horizon IRRs, doesn’t always distinguish between IRRs and annual returns. In two recent reports, US PE/VC Benchmark Commentary or Global ex US PE/VC Benchmark Commentary, you’ll find no mention of IRR.

Rich Carson, senior director of private investments and global investment research at Cambridge Associates, described IRRs as good proxies for annual returns for large data sets over long periods. In other scenarios, he acknowledged, they are not.

Still, Carson pointed to the many other tools the firm has developed to evaluate fund performance, such as modified public market equivalents and its oft-stated view that IRRs should be used in combination with other metrics. He noted the lengths that the firm goes in many of its reports, including its full benchmarks reports, to identify IRRs as such and to explain the methodologies underlying its indices.

After talking to me for this column, Carson emailed to say he has discussed with another executive ways that “we can double-down in our efforts to ensure clarity on this issue.”

The industry does need to do more. The cost of the extra pixels needed to write “IRR, a metric not directly comparable to the compound annual growth rates used to measure public equity returns” is low. The cost of misleading the public is high.

Action Item: Download the Deutsche Banc prospectus: