Private equity IRR fund accounting?

So I'm wondering which way PE firms calculate fund returns:
Say fund is $5b, 7 year horizon, they do 3 deals and invest the 5, sell 1 company at year 4, sell another company at year 6, sell the last deal at year 7. They return 25% on the first 2b investment sold at yr 4, 20% on the next 2b investment sold at yr 6, and 12% on the last deal sold at year 7.

Do they calculate the IRR as the money-weighted IRR each deal that was exited? (So $2b buyout sold year 4 at 25% annual became $4.9b, $2b buyout at 20% sold year 6 became $5.9b, and 3rd investment of $1b sold year 7 at 15% became $2.6b.) Do they ascribe 40%, 40% and 20% to those IRRs? Or do they assume the first two deals money that was returned was reinvested at 25% and 20% respectively, and skew the data to make the funds IRR look higher than it is.

I know that they do that for returns since inception. Where a firm has a vintage fund that performed at 40%, and in the accounting they assume those funds were reinvested at that rate permanently, so the firms since inception IRR will almost never change.

Yeah so I'm just trying to get clarity on whether the reported numbers are manipulated or solid and how they're done, because lord knows finance is full of goofy ways of accounting that make things look better

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Comments (12)

Apr 5, 2021 - 2:20am

Always interesting to get into the nitty gritty of these things. The comments below are for a whole of fund waterfall.

For fund levels returns IRRs, all cash flows into the fund (purchase price for investments, management fees and partnership expenses) and out of the fund (proceeds from sale of companies, dividend recaps etc) can be lined up and the latest NAV of remaining value of assets can be used to calculate IRR.

As you suspected, this can be "gamed" through a) early exits have an anchoring effect on IRR and b) use of subscription lines (where the fund borrows to fund the purchase of companies and call capital from LPs later) juices the IRR.

For individual asset returns, cash flows at just that company level will be used but really represent exit value or NAV divided by purchase price (ignoring interim cash flows for simplicity). So management fees or performance fees wouldn't be taken into account.

Apr 5, 2021 - 12:39pm

Of course, but moic is only as good as its related to it's time frame. A true IRR is a great metric. But the gaming of IRRs in PE seems absurd, and this is absolutely the metric that is most used for marketing and citing performance. Ask about PE returns or watch someone interviewed about them and IRR is the metric that will be quoted.

Does investor capital still get charged 2% management fee even when it hasn't been drawn down because they used subscription lines? Because juicing IRR would seem like a silly tradeoff if it comes at the cost of not collecting those fees (unless its a first fund and you need to have a sick IRR for marketing purposes)

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Apr 7, 2021 - 9:30am

I think you are right that there are multiple ways to calculate IRRs and GPs will usually pick the one that makes them look the best but as others have said, and from my own FoF experience, there are many other things to focus on. I have gone through performance for many GPs and the standard industry data request/format is that you get a list of companies in a fund with MOIC, DPI, and Gross IRR. For the fund level, you also get net multiples and IRRs on top. Usually, the excel or PDF will have a footnote stating if a line of credit was used or not. I have never seen anyone really care about that because at the end of the day an LP will look at their returns and for someone like an FoF, it helps to have some high IRRs as it makes your fund look better.

Also, most don't really care about IRR. Institutional investors go into PE to capture the illiquidity discount, diversification, to brag (if they are in a hot VC / PE firm), the co-investment opportunities, something a custom account just wants that GP in their portfolio bc he is BFF with the GP, etc. Liquidity and returns aren't on TOP of the list. The general rule of thumb is that if a fund return >2x net then it's a good fund, that's the benchmark. So if you have a fund with 2.4x net and IRR, you might be worried, but if the IRR is >15% and you are comparing it to a fund that is 1.7x net but 30%, you will most likely pick the 2.4x net fund. Relationships also play a big role, so if it's an experience (think proven) GP then LPs are more likely to back them even if some of the other funds look better (within reason ofc).  

When I looked at the performance I lined up the CFs from the investors' POV or if we were already invested then our CFs (remember that not all LPs will have the same CF pattern). Usually they don't provide more details than that unless asked and in our case, it was just not worth the effort as there were many other reasons for investing. SB if helpful.

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