Menu Our services in the selected location:
  • No services available for your region.
Select Location:
Remember my selection
Your browser is out of date.

Investment Ideas 2022: Explore three key themes dominating markets where investors might uncover potential opportunities. Read More

   

AXIOM OF CHOICE: MEASURING PRIVATE MARKET PERFORMANCE

December 15, 2022  |  8 Minute Read


Daniel Murphy

Head of Portfolio Solutions for Alternatives Capital Markets and Strategy

Daniel Murphy


Key Takeaways

  • Investors may face challenges managing private market portfolios due to their illiquidity, preventing traditional return metrics from judging the success of investments.
 
  • Two metrics—IRR and ROI—have been used in tandem by private markets investors for decades; we believe each is flawed in its own way but provide useful information the other does not.

 

  • Evaluating performance on an annualized return basis, combined with a minimum ROI return target, can help place illiquid investments on a similar evaluative footing as more liquid public market investments.

In our view, performance measurement in private assets suffers from a number of challenges. Irregular cash flows and infrequent valuations make it difficult to compare performance to other investments, while lagging and smoothing in valuations make periodic return measures unreliable over short horizons. Advanced techniques, like Direct Alpha and KS PME measures, have been developed to address some of these challenges, but even more fundamentally investors often struggle with whether to focus on annualized return metrics like the Internal Rate of Return (IRR) or measures of capital appreciation like the Return on Investment (ROI).1 Even when assessing relative performance, the decision remains whether to focus on IRR (Direct Alpha) or ROI (KS PME).

 

These two metrics have been used in tandem by private markets investors for decades; we believe each are flawed in its own way but provide useful information the other does not. The phrase “you can’t eat IRR”2 has often been used to highlight one of the shortcomings of the IRR calculation, which can be inflated by short-duration investments realized for small profits. On the other hand, the ROI is agnostic to how long capital is employed before being returned to the investor, making it difficult to compare investments with different holding periods. How should investors judge the performance of their private market investments?

 

 

Underlying Challenges

Before addressing this question, it is useful to examine why these performance metrics, rather than more standard time-weighted returns, are used in the first place. The fundamental issue comes back to the illiquidity of private market assets and the challenges investors face in managing these portfolios. From a performance measurement perspective, the two issues that drive the usage of these metrics are:

 

  1. Investors do not control the timing of cash flows. Unlike more traditional investments in public equity and fixed income, investors do not determine when capital is invested into opportunities, nor when these investments are sold and capital returned. Rather, investors make commitments, or promises to fund capital up to a certain amount, to private market managers who then identify investment opportunities and call for this capital when they want to transact. Similarly, investors do not have the option of easily selling their private market investments when they want to exit and lock in gains, limit losses, or rebalance into other assets. This may not be an issue from a performance measurement standpoint if investors had access to real-time valuations of their portfolios where they could calculate cash flow-adjusted time-weighted returns, but…

  2. Valuations are provided quarterly. Most private market investments only provide portfolio valuations on a quarterly basis, while cash flows can happen at any time. These valuations themselves are also only estimates arrived at through modeled expected future performance or subjectively chosen market comparables. Because these assets are not trading on an open market there is no regularly occurring price discovery process providing real-time valuations.

 

Taken together, these issues may preclude the use of traditional return metrics to judge the success (or lack thereof) of private market investments. Instead, investors have often borrowed the IRR calculation from corporate finance and capital budgeting, which can provide an annualized return metric for projects or investments that have irregular cash flows. Because different amounts of capital will be invested at different times, this measure can’t easily be applied to the initial capital outlay to calculate profit in dollars, but it can be used in conjunction with the ROI metric to more directly illustrate the profitability of the investment.

 

 

The Fully Invested Problem

Unlike private fund managers who can call down and return capital when they choose, investors like pension plans and endowments may need to keep their capital invested at all times in some asset or another, typically aiming to maximize the dollar value of their portfolios over a certain time horizon (and subject to various other requirements). This dollar-maximization approach often drives investors toward evaluating their private market investments on an ROI basis, but this can actually be counter-productive. Consider an illustrative example of an investor faced with two mutually exclusive investment options—one option that is expected to generate 1.5x capital invested over three years, versus another option expected to generate 2.0x capital invested over six years. The second investment option generates a higher ROI and so might be preferred, but if the investor has the opportunity to reinvest the proceeds from the first investment in a similar 1.5x, three-year hold investment, that approach would yield 2.25x the original capital invested over the same horizon.

 

Of course, there is no guarantee that a similar investment will be available in the future, but with the thousands of private market managers and dozens of strategies available in the market, it is not unreasonable to assume that opportunities of similar expected return characteristics could be found. If we could assume that reinvesting in similar opportunities was frictionless, then private market investments begin to look more like liquid investments that are continuously invested. Under this paradigm, investors would be more concerned with the rate at which their capital is compounding rather than the profits generated over an arbitrary time horizon, and it would seem that the IRR should win out as a performance measure. If an investment is accruing value at a higher rate, it should be preferred to one that is accruing more slowly on a risk-adjusted basis.

Clouding the Picture: Subscription Lines

The increasing usage of subscription credit lines has caused many to question the validity of Internal Rate of Return (IRR) and its susceptibility to manipulation. Indeed, we believe one of the benefits of sub lines is a potential mechanical enhancement to the IRR by shortening the time frame between cash contributions and distributions from and to Limited Partners (LP). Partially offsetting this dynamic is a decline in the overall Return on Investment (ROI) from the costs of the facility; however, we believe the benefits to IRR typically outweigh the downside to ROI, in addition the potential administrative benefits of sub line usage. Even with sub line usage, IRR will still be calculated on the actual LP cashflows, reflecting their economic reality, but we feel investors should be cognizant of the impact and evaluate the underlying sources of fund returns. For more detail on trends in private fund cash flows, including the impact of sub lines, read Calling Patterns.

Private Market Frictions

However, private market investments are not frictionless. The cash outlays for new investments are unlikely to exactly match the inflows from prior investments, requiring them to be reinvested in liquid assets for some period of time. Identifying, diligencing, and managing private fund commitments can be highly labor-intensive and costly for investors. And private fund managers often charge meaningful management fees on committed capital (not invested capital) in addition to performance fees taken from profits. This suggests two potential constraints on a purely IRR-oriented performance analysis: 1) the investment should generate sufficient profits to compensate the investor for the efforts of making and managing the investment, and 2) the investor should be receiving a meaningful share of the gross profits after fees.

 

The first constraint can vary depending on the resources and size of the investor. For example, a well-resourced investor making large commitments may find the marginal cost of making an additional commitment to be quite small relative to the expected profits generated. On the other hand, an investor making smaller commitments with more limited resources may need to ration the number of evaluations they undertake, requiring a higher level of profits per commitment to compensate.

 

The second constraint is more generalized (though different investors may demand a different minimum share of profits). Because many of the management fees charged in private market funds can be relatively fixed, they would represent a higher proportion of the gross profits at lower ROIs. The illustration below shows the share of gross profits taken by the investment manager at different levels of ROI assuming a 1.5% management fee and 20% performance fee. Many investors would expect that they receive at least half of the gross profits of an investment, which would imply a minimum ROI of 1.5x; for investors who demand and expect at least two-thirds of the gross profits, the minimum ROI increases to 2.1x. These ratios of course change with the fee structure employed, where lower fee rates or structures that charge on invested capital rather than committed capital would have lower minimum ROIs, and higher fees would elevate required ROIs.

 

 

Fees Can Have a Larger Impact on LP Share of Gross Profit at Lower ROIs

 

Source: Goldman Sachs Asset Management. For illustrative purposes only. Assumes a 1.5% management fee and 20% performance fee. As of November, 2022.

 

 

One Size Doesn’t Fit All

For ongoing diversified private market programs in long-term portfolios, evaluating performance on an annualized return basis, using IRR or Direct Alpha and subject to a minimum target ROI for each investment, can help place illiquid investments on a similar evaluative footing as more-liquid public market investments. Of course, not every investor is investing with an infinite or even multi-decade time horizon, nor is every investor seeking a diversified ongoing allocation to private markets. For investors with shorter time horizons or specific minimum capital needs on defined timelines, ROI may be a preferable metric. Investors with regulatory requirements around expense ratios may also need to demand a higher target ROI with greater flexibility on annualized returns. But for most investors managing multi-asset portfolios, we believe that seeking investments that generate a higher level of annualized returns should generate greater wealth outcomes over time.

 

 

 

 

Related Insights

Start the Conversation

Committed to providing you with the insights you need to build your practice.

 

1 The ROI can also be called the Multiple of Invested Capital (MOIC), or Total Value to Paid-In (TVPI).

2 Oaktree Capital Management, You Can’t Eat IRR. As of July 12, 2006.

Glossary:

IRR (Internal Rate of Return) is the discount rate that makes the net present value of all future cash flows zero.

ROI (Return on Investment) is a financial ratio used to calculate the benefit an investor will receive in relation to their investment cost.

Limited Partner the investors into private equity funds which are managed by a General Partner (GP)

Risk Considerations

Hedge funds and other private investment funds (collectively, “Alternative Investments”) are subject to less regulation than other types of pooled investment vehicles such as mutual funds. Alternative Investments may impose significant fees, including incentive fees that are based upon a percentage of the realized and unrealized gains and an individual’s net returns may differ significantly from actual returns. Such fees may offset all or a significant portion of such Alternative Investment’s trading profits. Alternative Investments are not required to provide periodic pricing or valuation information. Investors may have limited rights with respect to their investments, including limited voting rights and participation in the management of such Alternative Investments.

Alternative Investments often engage in leverage and other investment practices that are extremely speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the loss of the entire amount that is invested. There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. Similarly, interests in an Alternative Investment are highly illiquid and generally are not transferable without the consent of the sponsor, and applicable securities and tax laws will limit transfers.

Conflicts of Interest

There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. These activities and interests include potential multiple advisory, transactional and other interests in securities and instruments that may be purchased or sold by the Alternative Investment. These are considerations of which investors should be aware and additional information relating to these conflicts is set forth in the offering materials for the Alternative Investment.

General Disclosures

This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.

Examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially.

THIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORIZED OR UNLAWFUL TO DO SO.

Prospective investors should inform themselves as to any applicable legal requirements and taxation and exchange control regulations in the countries of their citizenship, residence or domicile which might be relevant.

This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. This material has been prepared by GSAM and is not financial research nor a product of Goldman Sachs Global Investment Research (GIR). It was not prepared in compliance with applicable provisions of law designed to promote the independence of financial analysis and is not subject to a prohibition on trading following the distribution of financial research. The views and opinions expressed may differ from those of Goldman Sachs Global Investment Research or other departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be current and GSAM has no obligation to provide any updates or changes.

Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources.

Views and opinions expressed are for informational purposes only and do not constitute a recommendation by GSAM to buy, sell, or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change, they should not be construed as investment advice.

Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur.

United Kingdom: In the United Kingdom, this material is a financial promotion and has been approved by Goldman Sachs Asset Management International, which is authorized and regulated in the United Kingdom by the Financial Conduct Authority.

European Economic Area (EEA):This material is a financial promotion disseminated by Goldman Sachs Bank Europe SE, including through its authorised branches ("GSBE"). GSBE is a credit institution incorporated in Germany and, within the Single Supervisory Mechanism established between those Member States of the European Union whose official currency is the Euro, subject to direct prudential supervision by the European Central Bank and in other respects supervised by German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufischt, BaFin) and Deutsche Bundesbank.

Switzerland: For Qualified Investor use only – Not for distribution to general public. This is marketing material. This document is provided to you by Goldman Sachs Bank AG, Zürich. Any future contractual relationships will be entered into with affiliates of Goldman Sachs Bank AG, which are domiciled outside of Switzerland. We would like to remind you that foreign (Non-Swiss) legal and regulatory systems may not provide the same level of protection in relation to client confidentiality and data protection as offered to you by Swiss law.

Asia excluding Japan: Please note that neither Goldman Sachs Asset Management (Hong Kong) Limited (“GSAMHK”) or Goldman Sachs Asset Management (Singapore) Pte. Ltd. (Company Number: 201329851H ) (“GSAMS”) nor any other entities involved in the Goldman Sachs Asset Management business that provide this material and information maintain any licenses, authorizations or registrations in Asia (other than Japan), except that it conducts businesses (subject to applicable local regulations) in and from the following jurisdictions: Hong Kong, Singapore, Malaysia, India and China. This material has been issued for use in or from Hong Kong by Goldman Sachs Asset Management (Hong Kong) Limited, in or from Singapore by Goldman Sachs Asset Management (Singapore) Pte. Ltd. (Company Number: 201329851H) and in or from Malaysia by Goldman Sachs (Malaysia) Sdn Berhad (880767W).

This material is distributed in Australia and New Zealand by Goldman Sachs Asset Management Australia Pty Ltd ABN 41 006 099 681, AFSL 228948 (’GSAMA’) and is intended for viewing only by wholesale clients in Australia for the purposes of section 761G of the Corporations Act 2001 (Cth) and to clients who either fall within any or all of the categories of investors set out in section 3(2) or sub-section 5(2CC) of the Securities Act 1978, fall within the definition of a wholesale client for the purposes of the Financial Service Providers (Registration and Dispute Resolution) Act 2008 (FSPA) and the Financial Advisers Act 2008 (FAA),and fall within the definition of a wholesale investor under one of clause 37, clause 38, clause 39 or clause 40 of Schedule 1 of the Financial Markets Conduct Act 2013 (FMCA) of New Zealand (collectively, a “NZ Wholesale Investor”). GSAMA is not a registered financial service provider under the FSPA. GSAMA does not have a place of business in New Zealand. In New Zealand, this document, and any access to it, is intended only for a person who has first satisfied GSAMA that the person is a NZ Wholesale Investor. This document is intended for viewing only by the intended recipient. This document may not be reproduced or distributed to any person in whole or in part without the prior written consent of GSAMA.

To the extent that this document contains any statement which may be considered to be financial product advice in Australia under the Corporations Act 2001 (Cth), that advice is intended to be given to the intended recipient of this document only, being a wholesale client for the purposes of the Corporations Act 2001 (Cth).

Any advice provided in this document is provided by either of the following entities. They are exempt from the requirement to hold an Australian financial services licence under the Corporations Act of Australia and therefore do not hold any Australian Financial Services Licences, and are regulated under their respective laws applicable to their jurisdictions, which differ from Australian laws. Any financial services given to any person by these entities by distributing this document in Australia are provided to such persons pursuant to the respective ASIC Class Orders and ASIC Instrument mentioned below.

  • Goldman Sachs Asset Management, LP (GSAMLP), Goldman Sachs & Co. LLC (GSCo), pursuant ASIC Class Order 03/1100; regulated by the US Securities and Exchange Commission under US laws.
 
  • Goldman Sachs Asset Management International (GSAMI), Goldman Sachs International (GSI), pursuant to ASIC Class Order 03/1099; regulated by the Financial Conduct Authority; GSI is also authorized by the Prudential Regulation Authority, and both entities are under UK laws.
 
  • Goldman Sachs Asset Management (Singapore) Pte. Ltd. (GSAMS), pursuant to ASIC Class Order 03/1102; regulated by the Monetary Authority of Singapore under Singaporean laws
 
  • Goldman Sachs Asset Management (Hong Kong) Limited (GSAMHK), pursuant to ASIC Class Order 03/1103 and Goldman Sachs (Asia) LLC (GSALLC), pursuant to ASIC Instrument 04/0250; regulated by the Securities and Futures Commission of Hong Kong under Hong Kong laws

 

No offer to acquire any interest in a fund or a financial product is being made to you in this document. If the interests or financial products do become available in the future, the offer may be arranged by GSAMA in accordance with section 911A(2)(b) of the Corporations Act. GSAMA holds Australian Financial Services Licence No. 228948. Any offer will only be made in circumstances where disclosure is not required under Part 6D.2 of the Corporations Act or a product disclosure statement is not required to be given under Part 7.9 of the Corporations Act (as relevant).

FOR DISTRIBUTION ONLY TO FINANCIAL INSTITUTIONS, FINANCIAL SERVICES LICENSEES AND THEIR ADVISERS. NOT FOR VIEWING BY RETAIL CLIENTS OR MEMBERS OF THE GENERAL PUBLIC.

Canada: This presentation has been communicated in Canada by GSAM LP, which is registered as a portfolio manager under securities legislation in all provinces of Canada and as a commodity trading manager under the commodity futures legislation of Ontario and as a derivatives adviser under the derivatives legislation of Quebec. GSAM LP is not registered to provide investment advisory or portfolio management services in respect of exchange-traded futures or options contracts in Manitoba and is not offering to provide such investment advisory or portfolio management services in Manitoba by delivery of this material.

Japan: This material has been issued or approved in Japan for the use of professional investors defined in Article 2 paragraph (31) of the Financial Instruments and Exchange Law by Goldman Sachs Asset Management Co., Ltd.

South Africa: Goldman Sachs Asset Management International is authorised by the Financial Services Board of South Africa as a financial services provider.

Malaysia: This material is issued in or from Malaysia by Goldman Sachs (Malaysia) Sdn Bhd (880767W)

Hong Kong: This material has been issued or approved for use in or from Hong Kong by Goldman Sachs Asset Management (Hong Kong) Limited.

Singapore: This material has been issued or approved for use in or from Singapore by Goldman Sachs Asset Management (Singapore) Pte. Ltd. (Company Number: 201329851H).

Bahrain: This material has not been reviewed by the Central Bank of Bahrain (CBB) and the CBB takes no responsibility for the accuracy of the statements or the information contained herein, or for the performance of the securities or related investment, nor shall the CBB have any liability to any person for damage or loss resulting from reliance on any statement or information contained herein. This material will not be issued, passed to, or made available to the public generally.

Kuwait: This material has not been approved for distribution in the State of Kuwait by the Ministry of Commerce and Industry or the Central Bank of Kuwait or any other relevant Kuwaiti government agency. The distribution of this material is, therefore, restricted in accordance with law no. 31 of 1990 and law no. 7 of 2010, as amended. No private or public offering of securities is being made in the State of Kuwait, and no agreement relating to the sale of any securities will be concluded in the State of Kuwait. No marketing, solicitation or inducement activities are being used to offer or market securities in the State of Kuwait.

Oman: The Capital Market Authority of the Sultanate of Oman (the "CMA") is not liable for the correctness or adequacy of information provided in this document or for identifying whether or not the services contemplated within this document are appropriate investment for a potential investor. The CMA shall also not be liable for any damage or loss resulting from reliance placed on the document.

Qatar This document has not been, and will not be, registered with or reviewed or approved by the Qatar Financial Markets Authority, the Qatar Financial Centre Regulatory Authority or Qatar Central Bank and may not be publicly distributed. It is not for general circulation in the State of Qatar and may not be reproduced or used for any other purpose.

Saudi Arabia: The Capital Market Authority does not make any representation as to the accuracy or completeness of this document, and expressly disclaims any liability whatsoever for any loss arising from, or incurred in reliance upon, any part of this document. If you do not understand the contents of this document you should consult an authorised financial adviser.

The CMA does not make any representation as to the accuracy or completeness of these materials, and expressly disclaims any liability whatsoever for any loss arising from, or incurred in reliance upon, any part of these materials. If you do not understand the contents of these materials, you should consult an authorised financial adviser.

United Arab Emirates: This document has not been approved by, or filed with the Central Bank of the United Arab Emirates or the Securities and Commodities Authority. If you do not understand the contents of this document, you should consult with a financial advisor.

Israel: This document has not been, and will not be, registered with or reviewed or approved by the Israel Securities Authority (ISA”). It is not for general circulation in Israel and may not be reproduced or used for any other purpose. Goldman Sachs Asset Management International is not licensed to provide investment advisory or management services in Israel.

Jordan: The document has not been presented to, or approved by, the Jordanian Securities Commission or the Board for Regulating Transactions in Foreign Exchanges.

Colombia: Esta presentación no tiene el propósito o el efecto de iniciar, directa o indirectamente, la adquisición de un producto a prestación de un servicio por parte de Goldman Sachs Asset Management a residentes colombianos. Los productos y/o servicios de Goldman Sachs Asset Management no podrán ser ofrecidos ni promocionados en Colombia o a residentes Colombianos a menos que dicha oferta y promoción se lleve a cabo en cumplimiento del Decreto 2555 de 2010 y las otras reglas y regulaciones aplicables en materia de promoción de productos y/o servicios financieros y /o del mercado de valores en Colombia o a residentes colombianos. Al recibir esta presentación, y en caso que se decida contactar a Goldman Sachs Asset Management, cada destinatario residente en Colombia reconoce y acepta que ha contactado a Goldman Sachs Asset Management por su propia iniciativa y no como resultado de cualquier promoción o publicidad por parte de Goldman Sachs Asset Management o cualquiera de sus agentes o representantes. Los residentes colombianos reconocen que (1) la recepción de esta presentación no constituye una solicitud de los productos y/o servicios de Goldman Sachs Asset Management, y (2) que no están recibiendo ninguna oferta o promoción directa o indirecta de productos y/o servicios financieros y/o del mercado de valores por parte de Goldman Sachs Asset Management.

Esta presentación es estrictamente privada y confidencial, y no podrá ser reproducida o utilizada para cualquier propósito diferente a la evaluación de una inversión potencial en los productos de Goldman Sachs Asset Management o la contratación de sus servicios por parte del destinatario de esta presentación, no podrá ser proporcionada a una persona diferente del destinatario de esta presentación.

Date of First Use: December 15, 2022 299804-OTU-1709916

Please enter your email address to continue reading.

Confirm Your Access


An email has been sent to you to verify ownership of your email address.

Please verify the link in the email by clicking the confirmation button. Once completed, you will gain instant access to our insights.

If you did not receive the email from us please check your spam folder or try again.