Why does IRR matter?
From an LP perspective, why does IRR matter? Given that IRR is based on the time value of money, more realizations in the beginning will juice IRR, even though MOIC could be the exact same.
Why don't LPs just calculate PE fund performance as: MOIC divided by the duration of fund life?
As a hypothetical example, if you have a fund that will invest and fully realize over 7 years that has an IRR of 15% and a MOIC of 1.5x, but another fund has an IRR of 11% and the exact same MOIC of 1.5x, wouldn't a better judge of actual performance be MOIC / 7 years?
You answered your question for yourself in the first paragraph. If you have two funds that both returned 1.5x but one has a 12% IRR and one has an 8% IRR which one would you have preferred to be in? Obviously the higher IRR because you got money back faster.
LPs care about IRR, MOIC, and increasingly DPI (distributed paid-in capital).
IRR by itself doesn't work because of what you said.
MOIC by itself also doesn't work - great you returned 3x - but it took 15 years.
DPI measures what you funds actually returned - dirty little secret is that in the last 10 years, many funds have not even returned 1.0x of their invested capital (while claiming that the assets are worth ~2x)
Thanks. Could you elaborate what DPI is? I'm a bit confused on how that differs from MOIC.
DPI is a fund level metric of distributions / contributions.
MOIC is deal level metric which also factors in unrealized (NAV).
TVPI (Aka MOIC) = DPI + RVPI
In my opinion literally nothing matters besides DPI. Probably DPI + IRR cuz then you have some perspective on the timing of cash flows but until it’s realized… a GP’s marks mean virtually nothing and hence why funds that actually hit a DPI of 2.0x are pretty impressive.
Can’t eat paper returns.
Like most things in investing, you have to look at all the pieces and it all becomes much more "art" than science.
Can't look only at DPI because of the J-curve and the investment cycle - if you only looked at DPI, you won't be able to tell what funds are actually good / bad for 10+ years (through the deployment and harvesting period).
Lastly, to understand why the industry is structured this way it's useful to think through incentives. Who does private mark-to-markets benefit? The GP for sure. But also the LPs. In times when the S&P 500 dips 40% (like we had during COVID), the pension / endowments get to represent with a straight face that their private investments were "much more immune" to the downturn. So when everything was going up and everyone was making money, it was in no one's best interest to scrutinize DPI too much - but as you alluded to, the tide has gone out.
IRR would also include unrealized “paper “ returns. Since you’d essentially run the actual cash flows with a terminal value assumption as of the calculation date.
Because every quarter they mark their investments "to market" which we all know is complete nonsense.
So they've distributed some money out but not a lot. But they apparently have their investments marked pretty nicely... thus the high IRR.
The other important thing that IRR picks up is when the capital is called from LPs. I don't know enough about LP capital allocation / reserve strategy, but I'm sure they could put committed capital to work in at least treasuries and earn a return before it is called from the GP.
Great. 2% yield in a 10-year (prior to last 2-years) while the S&P 500 is up 25% - 40% unlevered...
That's irrelevant
Disagree and wrong.
Basically - PE returns when viewed through (i) realized performance, (ii) the actual opportunity cost (including public markets / cost of capital sitting in low-yielding treasuries) is materially below what they are marketed to be. And that will result in both fee compression and slowing growth / reversal in the asset class.
Again irrelevant. We're not talking about the attractiveness of PE as an asset class. Merely discussing merits of using IRR vs. MOIC, other metrics, etc. I don't think it's a big revelation to anyone that fund managers really dress up their marketing stats and that the asset class has not performed as well as public markets in the past few years.
Isn’t there too an opportunity cost for LPs when they’re investing in public market GPs (LO AMs, HFs, etc.) in terms of the time taken to deploy the capital? Also, these LPs are presumably exposed to public market opportunities so they don’t necessarily care much when their unallocated PE contributions take some time to be deployed. That 25-40% you mention is something they’re benefiting from.
You're going to stay an IB "hopeful" if this is the extent of your understanding of PE. Love the LARP title though.
Put it in terms that you're more likely to relate to...you have $10k in 2 separate Robinhood accounts, and they both double your money over time. If one takes 10 years and the other takes 5 years to do the same goal, which would you prefer? Obviously, you would want it in the account that grew the fastest year-over-year. As an LP, you want your money to grow as fast as possible, and the IRR is the annual growth rate of that money so the higher the number, the happier you are. Not to say MOIC or any other return metrics aren't as valuable, they all have their own uses, but IRR gives a general idea of the return to be expected each year from your initial investment.
Sigh. It's not CAGR.
Cuz time matters
Howard Marks wrote a memo on it
If you don't think IRR matters then you've been reading too much tripe on LinkedIn from that bafoon Ludovic Phallapou that simply hates the entire world. It is an imperfect metric but when you view it in conjunction with TVPI, DPI, and PIC it is powerful.
Not a comment on the legitimacy of the metric, but in my experience, a lot of private markets LP investment teams align their bonus metrics to IRR performance relative to benchmarks, so that's a big part of why they care.
Using your example:
You invest $100 in Y0, the investment generates $15 for you every year until year 7 ($105 total annual cash flow) when you sell for $100. Your IRR is 15% and MOIC is ~2x
Another fund also requires a $100 investment but generates $0 from years 1-6 and get everything at the end ($100 from sale and $105 cash flow from a total of $205 in year 7). Your IRR is 11% and your MOIC ~2x.
Which do you prefer? Obviously the one where you got the money early, and that is what IRR is telling you (time value of money, those $15 of annual cash flow could be invested in something else generating a return).
There are some inherent assumptions in IRR that makes it an imperfect metric (it assumes you reinvest the cash flows at IRR, which may not be realistic as you may not find another investment that yields the same return) and that’s why you combine it with other metrics like MOI and DPI.
So, if you only use MOIC, you are not taking into account TVM (so you would not distinguish between doubling your money over 2 years vs doubling your money over 7 years). On the contrary, if you only use IRR, your returns could be misleading because you could buy something for $100 and sell it for $115 after 1 year getting the same 15% annual return, but then you only multiplied your money by 1.15x and you will need to find another investment to put that money and u may not be able to find another 15% annual return investment. That’s why you use both as well as other metrics like DPI/CoC/etc.
Hope it makes sense
IRR is basically the compounded rate of return since you adjust to the time factor, a great measure for return on an investment for private equity firm
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