Carnegie Mellon Research on Private Equity IRR

A couple of Carnegie Mellon professors looked into how private equity funds have used subscription lines of credit to improve their performance.

Using data from Burgiss, an analytics provider for private capital investors, the two assistant finance professors [James Albertus and Matthew Denes] calculated how a private equity fund’s IRR would change if it had called capital from investors rather taking out a subscription line of credit. They found that the use of these loans resulted in a “substantial” increase in IRR, with the effect amplified for younger funds.

However, when they evaluated the same funds using a multiples-based measure of performance — as opposed to IRR, which is based on cash flows — Albertus and Denes found that subscription credit lines did not improve private equity returns. In fact, the total value to paid-in multiple, or TVPI, was slightly lower due to managers paying interest on the loans.

Private Equity Returns Are Being ‘Distorted’ by Loans, Research Finds, Institutional Investor

Although using subscription lines of credit is a recent phenomena in the private equity world, it is making it difficult to rely on IRRs to assess a fund manager’s performance.

The use of a subscription line of credit [SLCs] could also alter the perceived performance and fees generated for GPs. In particular, by shortening the period of outflows, or negative cash flows, performance measured using the internal rate of return (IRR), a widespread metric in private equity markets, can be inflated. If investors do not understand how SLCs adjust IRR-based performance, then a private equity firm could potentially raise additional capital for future funds using the relatively higher measure of performance. Additionally, the use of a subscription line of credit might increase the fees from carried interest. Since an SLC could increase a private equity fund’s IRR, it may become more likely for the fund to reach its hurdle rate. Taken together, these reasons provide GPs with a strong incentive to use SLCs.

Distorting Private Equity Performance: The Rise of Fund Debt

LPs can’t eat IRRs but GPs apparently can.

Carnegie Mellon University campus.
Twitter @CarnegieMellon

Post by Marcelino Pantoja