What’s in a return? That might sound like a facetious opening question. After all, every private markets professional worth his or her salt knows very well what an internal rate of return is. So perhaps a better question is: what’s not in your average private infrastructure fund return?
The answer, according to the husband and wife team of Simon and Jessica Wilde, is the story of what happens with the interim payments doled out during a fund’s lifecycle and how a fund’s return compares to the wider markets.
The Wildes are not the first researchers to wonder about the adequacy of IRR as a measure of performance. In private equity, academics came up with the concepts of modified IRR and public markets equivalent to try and shine a more accurate light on that asset class’ performance. But Simon Wilde, a Macquarie Capital senior managing director, may well be the first academic applying MIRR and PME to infrastructure in the context of his PhD research at the University of Bath.
In the September issue of Infrastructure Investor, the Wildes analyse the cashflows of 47 unlisted infrastructure funds with vintages from 2002 to 2012. What they find is both thought-provoking and controversial. And it’s this: that the sample’s average MIRR of 8.5 percent trailed noticeably behind its 11.7 percent IRR; and that the sample’s S&P 500-indexed PME is 0.96 percent, meaning it actually underperforms, albeit slightly, the US equities market.
For those not in the know, MIRR looks at the assumed returns on cashflows distributed during a fund’s lifecycle and factors them into the overall return calculation. That means a higher or lower re-investment rate for those interim returns will skewer a fund’s total return accordingly.
PME, for its part, is calculated by comparing cashflows against an index of total returns, such as the S&P 500. A higher than one PME means returns are outperforming the index; anything below speaks to underperformance.
On the face of it, then, the Wilde’s headline findings seem like bad news for the asset class, with unlisted funds not only returning less than what they say on the tin but actually underperforming the wider equities market too. Of course, it’s not that simple.
Firstly, as the Wildes readily admit, their sample is small, which cautions against extrapolating their findings too widely. Secondly, when it comes to MIRR, a manager can plausibly argue that it’s not really its fault if its LPs fail to re-invest proceeds at the same rate of return that the manager’s vehicles generate. Thirdly – and again the Wildes also admit to this – there is much debate about which indices should be used in a PME comparison. And fourthly, MIRR and PME say nothing about infrastructure’s diversification benefits, its risk profile, or what it does for a particular investor’s portfolio.
So what’s all the fuss about then? The fuss is that more precise metrics help investors decide what they really can and should plausibly be expecting from their infrastructure investments. It sharpens questions around investment duration and capital preservation and forces investors to take a harder look at what different asset classes do for their overall portfolios. And finally, the work done in Bath shows just how little unlisted fund data is readily available to those who want to probe more deeply – including investors.
Infrastructure is on the verge of becoming a very significant asset class driven by the record low-interest rate environment, lack of public funds to spend on it and a growing demand for new assets. As more and more investors eye it, it’s time to pose the kinds of questions the Wildes are asking. Whether you agree with them or not, their findings are certainly worth discussing.