December 15, 2022 |
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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:
- 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…
- 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.
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