An IRRitating metric

Is the internal rate of return the most appropriate way to present investment performance?

“You can’t eat IRR,” said Oaktree Capital Management’s Howard Marks in a 2007 memo to investors. Though more than a decade has passed, the debate about the usefulness of internal rate of return rumbles on.

The way IRR is calculated places undue weight on distributions that come early in a fund’s cycle. This allows vehicles with strong early distributions to build up impressive rates of return – sometimes, some claim, by exiting investments before they should – and then coasting or declining.

One investor our sister publication Private Equity International spoke to believes “manipulation” of IRR has become worse in recent years. He argues the proliferation of subscription lines, which lead to capital calls being deferred, has further distorted the figures some funds present to investors.

Ludovic Phalippou, associate professor of finance at Saïd Business School at the University of Oxford, is one of the most outspoken critics of the metric. When asked why people still use IRR, his response was: mainly, because everyone else uses it.

“[Investors say] ‘Other people are using junk, so I’m going to use junk so it’s a fair comparison’. It’s not fair. Junk is not comparable to other junk. You cannot rate junk.”

Investors are increasingly favouring money multiples as a measure of performance. The total value-over-paid-in multiple, which combines the distributed and residual value to paid-in ratios, probably gives the clearest idea of how much the amount invested grows or shrinks.

A number larger than one means the investor gets their money back and more, while anything below one means the opposite. This allows for comparison between funds of different size and vintage, as returns are expressed in proportionate rather than absolute terms. However, unlike IRR, it doesn’t take into account the time taken for a return to be achieved.

“If you’re completely divorced from the notion of the time it takes to generate the multiple, you’re missing one of the critical components of underwriting private equity managers,” says Brian Rodde, managing director of Makena Capital, which was spun out of Stanford Management Company in 2005 and now invests around $500 million a year in private equity on behalf of endowments.

Phalippou argues that the best metric is the simplest: net present value. Take the returns, set them against a comparable public market benchmark, use an appropriate discount rate and check to see if the fund or investment has performed better or worse. One investment director at a large family office agrees, provided a suitable benchmark is used.

“Some GPs that pitch to us will benchmark against the S&P 500,” he says. “Those stocks are way larger [than the average PE-backed company].”

But even investors who have encountered GPs with a creative approach to presenting their returns don’t feel strongly about pushing for change. In fact, “the more performance data we can get the better” was a common refrain. The investor should have the knowledge and the resources to make the best decision for themselves.

“It’s incumbent on LPs to ask questions until they get satisfactory answers,” said Rodde.

Rod James is a reporter at sister publication Secondaries Investor. Write to him at