Private Equity’s Trick to Make Returns Look Bigger

Most important performance number in the private-equity world is at risk of being massaged in a way that undermines the industry’s credibility.

It is perhaps the most important number in the private-equity world. It is also at risk of being massaged in a way that undermines the industry’s credibility and adds dangers when a downturn comes.


The internal rate of return is the key performance metric published by private-equity firms. A percentage that measures annualized returns, the IRR is based on a complex set of numbers tied to fund cash flows. Investors use IRR to choose which funds to invest in.

But the growing use of hidden borrowing, known as subscription-line or bridge financing, is flattering the IRR figures some funds report.

It works like this: As funds identify investments, they traditionally call on their investors, known as limited partners, to pony up the cash they committed to supply when the fund was put together. But instead of calling that cash as soon as an asset to buy is identified, the funds borrow money to make the investment, tapping investors’ cash later.

This began as a way simply to make capital calls more predictable for LPs, and in itself such borrowing doesn’t boost a fund’s cash profits.

But crucially it shortens the time during which investors’ cash is actually in the fund. When you shorten the apparent time it takes to generate a cash profit, that boosts the IRR—sometimes in a very big way.

The trouble is, fund managers, investors and the consultants who advise them may not have an interest in rocking this boat: Internal rates of return are the key statistic that determines how much (and when) most of these people get paid. It also makes a good impression, say, with a pension fund investor committee that oversees how money is allocated among bonds, stocks and private equity.

But some investors are growing more worried about the damage that might be done by this borrowing. They fear first that it will increasingly distort returns data across the industry, making them less reliable.

Potentially worse is the risk that funds will face in a cash crunch if markets turn, banks withdraw the financing and some investors can’t deliver their fund commitments, even after their money has in effect already been spent.

Huge jumps in IRRs can occur when funds use bridge financing and resell investments quickly, says Oliver Gottschalg, a professor at HEC, a French business school, and head of research at Peracs, a consulting firm that analyzes private-equity returns.

“For 80% of funds, short-term use of bridge finance lifts IRRs by less than a percentage point, but for a few, the IRR goes through the roof,” he says.

Prof. Gottschalg’s analysis is based on cash-flow data from 149 fully mature funds that began investing between 2003 and 2006. He recalculated their IRRs to add in simulated use of bridge financing on the funds’ first capital call for up to 360 days.

Much of his work is based on bridge financing that lasts just 90 days. However, funds now regularly use it for six months or a year and some are pushing that to 18 months or more, investors say. The longer that funds hold investments without calling on investors’ cash, the greater the boost to IRRs.

So who are the worst offenders? It’s hard to say because most private-equity firms don’t disclose this financing other than to existing investors. And while investor bodies are working to improve transparency, the industrywide returns data from consultants like Cambridge Associates or Preqin can’t yet correct for the effects of financing. Nobody knows how important it is.

There may already be an arms race under way as firms compete to show the best returns data. At a time when private-equity deals are being done at high valuations and some think a downturn in markets is already overdue, this is a growing, hidden financial risk.

Corrections & Amplifications 
An earlier version of this story misnamed Cambridge Associates as Cambridge Analytics. (March 9, 2018)

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