Private equity has some cerebral new opponents. Business academics increasingly criticise buyout groups for high fees, misaligned incentives and returns that may be mediocre or opaque. Stanford University researchers are the latest to take a swipe. In a recent paper, they spotlight the weaknesses of “internal rates of return”, the profitability benchmarks the industry markets itself with.
IRRs have the benefit of simplicity. Cash inflows and outflows for a private equity fund are mapped then reduced to a single percentage that can be benchmarked against other asset classes.
But in a recent study titled “An Economic Case for Transparency in Private Equity” the authors pointed out how misleading IRRs can be. For example, modest differences in the timing of similar underlying cash flows can lead to widely differing IRRs.
Another original sin in private equity has been high pay for poor performance. IRRs are implicated. In many funds, managers only earn performance fees when IRRs exceed a hurdle rate. This is meant to align incentives. But when managers are desperate to beat their targets, the mechanism can encourage massaging of numbers and excessive risk taking.
Such critiques irritate rather than constrain the Masters of the Universe. Private capital keeps growing. Wealth funds and government pension schemes are allocating growing sums to the alternative asset industry. This now has about $5tn of “dry powder” — as cash for investment is called. The likes of California state retirement fund Calpers have been tilting allocations away from public markets.
The researchers hope to create a more holistic and granular standard for private equity returns. This would be based on factors broader than a single percentage. The academics advocate building computer models that permit micro analysis of deal risk, conflicts and profitability.
In recent years, pension schemes have been engulfed in scandals about “pay-to-play” clauses over rescue financings. Some have simply lost track of fees paid to private equity managers. Overwhelmed bean counters at state pension offices need to get a better handle on the basics of their job. After that, they can start thinking about replacing IRRs with better benchmarks.
The Lex team is interested in hearing more from readers. Please tell us what you think of the Stanford researchers’ criticisms of IRRs in the comments section below.
