value and opportunity

These days, more and more offerings for Private Investors are popping up to participate in Private Equity, which until now was mostly exclusive for Institutional investors and very wealthy people. In Europe, the socalled ELTIF II format allows now fund companies to directly target individual investors from as low as a few thousand EUR.

Private Equity in my opinion has its place. The good Private Equity funds are indeed “value investors” that have a decent ability to identify undervalued assets. However, Private Equity Investing also is not directly comparable with investing into public markets.

In particular, any prospective investors should take any returns stated by PE funds with a grain of salt and I want to explain why these “PE IRRs” cannot be directly compared with Stock market performance. This is due to 2 main differences:

Critical point 1: IRR calculation – critical assumption: Reinvestment at the IRR is possible

The Internal Rate of Return calculation in simple words calculates a single discount rate that makes all future cashflows of an investment equal in discounted value to the initial investment. The easiest case is if you have only one outflow and one inflow. Then the internal rate of return is easy to calculate. Here is an easy example: If you invest 100 and receive back 400 after 12 years, your internal rate of return = performance is 12,25%:

It gets more complex when you have more than one cash inflow in the future. The IRR calculation implictly assumes that you can reinvest any positive cashflow you receive in the periods before the final period at the calculated IRR.

Example 2 shows the same overall Cashflows but the positive cashflows come distributed over the last 3 years (typical for a PE fund), a little bit earlier which increases the IRR:

The way the formula works, it assumes, that the 100 in Year 10 can be invested at the (higher) IRR of 13,29% for 2 years and the 140 in year 11 can be invested for 1 year at 13,29%.

However, in reality, you cannot invest the proceeds back at that IRR into the same fund. You can do this for a liquid stock portfolio or an ETF, but not for a P/E fund because it’s a closed fund. Maybe you can reinvest into the next generation of the PE fund, but especially in the early years, the returns are usually not so good. Depending at what rate you are able to reinvest, the actual performance might be significantly lower than the stated IRR of the fund.

Here is an example where the reinvestment yield is 2% for the same cashflows as before:

We can see, that the investor loses ~0,9% p.a. just for these two cashflows based on a lower reinvestment yield.

Point 1 to remember: It is not possible to reinvest into a PE fund, therefore, especially for high IRRs, the actual performance for an LP/Investor wll be (significantly) below the stated IRRs as the actual reinvestment rate will be lower.

Critical Point 2: Capital calls are not foreseeable

A typical PE Funds does not collect all the money upfront, but requires investors to sign a “commitment” of a certain amount that will be drawn down on the discretion of the GP over a period of several years, the so called “investment period”. Although investors might have some expectation based on past funds, they need to honor those capital calls when they come. They usually happen on a quarterly basis with around 2 weeks of advance notice and can be very lumpy. So obviously, an investor needs to have some cash available in order to honor these calls.

This is how a simplified pattern could look like from the Fund’s perspective:

As capital gets drawn later, the IRR increases compared to example 2 with the initial bullet payment. And this is the main reason why PE funds work this way: As they are paid based on IRR (i.e. the typical carry of 20% above a certain preferred rate like 8%), the higher the IRR, the more money they make.

As mentioned above, the investor however has the issue that the cash needs to come from somewhere. Holding all the cash from day one is clearly a too conservative assumption, however holding no cash at all is clearly too optimistic. Especially in the current environment, large institutional investors cannot sell easily their underwater bonds or real estate and existing PE funds do distribute less than expected.

So from an investor perspective, assuming to hold some cash to back the commitment and the capital calls is realistic. If we assume for instance that an investor will hold 50% of the estimated amount of the following year, the IRR would look as follows:

That’s a decrease of ~0,8% p.a. just because you need to hold some buffer against these unpredictable capital calls.

Cash buffer and Reinvestment effect combined:

If we put these two effects together, we get this IRR:

And once more compare this to the IRR calc from the Fund’s perspective:

These two effects ae costing around 1,8% of annual performance for the investor compared to the number that the fund reports. And remember: If you invest into an ETF, you don’t need a cash buffer and you can always reinvest any proceeds into the underlying at the same IRR

Summary:

There are many more “little tricks” in the PE industry on how to extract more money from investors. However, in this post I just wanted to make one point: Whenever you see “returns” from Private Equity funds, these returns are theoretical IRRs and not real investor returns. Real returns are significantly lower, as an investor has to hold extra cash in order to fund capital calls and the inability to reinvest at the IRR rate.

As a rule of thumb I would guess that the “real performance” of PE investors is around ~2% p.a. lower than stated IRRs based on these effects.

And as a retail investor you will need to factor in an extra layer of expenses that will further reduce your return, not to speak of “adverse selection” effects etc.

My personal bet is that all these retail PE products will significantly underperform public equity markets.In the coming years. In addition, I also think that this is one of the reasons why Investment Companies with a high PE Fund exposure in reality never outperform the stock market.

However more on this in subsequent posts on that topic.