Is it time for a better way to compare Private Investment Returns to Public Investments?
“Things should be as simple as possible, and no simpler.”
Einstein’s simple quote.
Everyone wants simple illustrations and comparisons, but in an effort to create them, are comparisons sometimes too simple?
In the investment world, we see this in presentations that simply compare private investment Internal Rates of Return (IRRs) to public investment returns.
In an effort to create better comparisons, many commonly reported solutions modify public market returns to make them more comparable to private market returns.
We appreciate these methods, which create Public Market Equivalents or PMEs. They also allow for simple illustrations. Some make us wonder, however…
Do Current Solutions Modify the Wrong Thing?
Many PME methods modify annualized public market returns, but then still compare them to the “unrealistic” IRRs that McKinsey and others have cautioned investors about for decades (for more on this read Cautionary Tales).
Because of this, a few of the more commonly presented methods have weaknesses (see the chart below).
Source: An ABCs of PME – Stucke, Griffiths, and Charles – 2014
Some PMEs are simple, but maybe too simple.
What Might Be A Better Solution?
They call their approach a Duration Adjusted Return Calculation or DaRC.
Some complexity is required but…
As simply as may be possible, DaRC allows investors to make comparisons of annualized public market time-weighted returns to annualized private market time-weighted returns – more apples to apples.
The term duration is used in the name to reference the concept of time-weighting, which can be critically absent in an IRR calculation.
DaRC time-weights private investment returns, using techniques that have been utilized in the modeling of fixed income returns for many years.
Like bonds, private investments have cash flows and liquidate at maturity or the end of a fund. Also similar to bonds, when cash is returned or distributed from a private investment fund, investors have to then reinvest the funds themselves. Due to this, they face the risk that the distributions they have received will not earn the same return in the future. A fundamental problem with IRR is that it does not take this into account.
IRR assumes investors will be able to receive the same returns that they have received inside a private fund – that past returns will equal future returns.
Put another way, IRR does not take into account re-investment risk – the real-world issue that investors need to find new investments for their distributions that may earn different returns than they have received from previously matured or liquidated investments.
With bonds, the return calculation problem is solved with a type of duration calculation, which takes into account the weighting and timing of interest or cash flows that are distributed to investors.
DaRC does something similar. The method weights the timing of cash flow distributions made by private investment funds.
Importantly, DaRC also weights the timing of private fund additions or calls. This helps account for the fact that with private investment funds, money an investor wishes to invest is not invested immediately. Funds that an investor has allocated might not be called for quite some time, if ever. Due to this, investors may keep larger amounts of cash on hand or place un-called funds in relatively safe but lower projected return investments. This leads to what might be called un-investment risk.
By taking into account the weighting and timing of both distributions and additions, Saccone’s DaRC method creates time-weighted returns for private investment funds that are similar to the time-weighted returns that are reported for public funds or indices.
As Howard Marks once said, a “multi-dimensional” approach to evaluating private investments is required. It is complex, but DaRC may help make the comparison of private investments to public investments as simple as it can be.
We are not alone in feeling that existing private equity return metrics, such as IRR, and some forms of PME comparisons, have historically left much to be desired.
The SEC now seems to agree (see the first two links below under Related Reading).
By promoting discussion of this new method, we hope to foster constructive debate about solutions that increase understanding and transparency.
Many good private investment opportunities exist and we are in favor of investors having access to attractive investment solutions.
If we had better ways to evaluate private investments in more of an apples-to-apples manner, we believe it would increase trust, putting both the industry and investors in a better position to form stronger, more lasting partnerships.
SEC Private Fund Risk Alert – 2022
An Economic Case for Transparency in Private Equity – Ashby Monk, Sheridan Porter, and Rajiv Sharma – 2021
DaRC Detailed – Resetting the Clock on Private Equity – CFA Institute – 2020
You Can’t Eat IRR – Howard Marks – 2006
Internal Rate of Return: A Cautionary Tale – McKinsey & Company – 2004
Special Thank You:
A special thank you to Massimiliano Saccone for his help with this piece. More on his approach and work can be found at the link below.