September 23, 2020

How to evaluate private equity funds: IRR v. NPV

We learn in finance class that investments should be evaluated based on their Net Present Value (NPV). It turns out that many private equity funds instead use the Internal Rate of Return (IRR) to advertise their performance. Do we learn something wrong in class? Or do private equity funds have (good or bad) reasons to communicate their internal rate of return?

Private equity (PE) funds invest in private companies, that is, companies which are not listed in the stock market. PE funds can invest directly in private companies, or buy out listed companies and take them out of the stock market.

Using the IRR as a performance metric leads to inefficient decisions

Consider a PE fund that raises 100 from investors (which are called Limited Partners) in year 0. The fund invests in two young companies: 50 in company A and 50 company B. It quickly becomes apparent that company A is very successful and the fund's investment in the company could be sold at 90. By contrast, company B is doing just fine and the fund's investment in the company is still worth 50.

Suppose the fund can choose either to exit quickly its investments in the companies or to remain invested for five more years. If it remains invested, the values of companies increase two-fold over the next five years.

Remaining invested is the best option because a doubling of the value in five years implies an annual return of 21/5-1 = 15%. This is higher than the average stock market return, which has been 11% over the past half-century. Therefore, the PE fund should remain invested in both companies.

However, exiting company A leads to a higher IRR than remaining invested in company A. Let us see why.

If the fund remains invested, the cash flow is:

    Year 0: -100
    Year 5: 90*2 + 50*2 = 280

The IRR is (280/100)1/5-1 = 23%

Consider now what happens if the fund exits quickly its investment in company A. To keep things simple, suppose the fund sells its shares in company during year 0 (the conclusion is the same if the fund sells the shares in year 1). The cash flow is:

    Year 0: -100+90 = 10
    Year 5: 50*2 = 100

The IRR is (100/10)1/5-1 = 58%

Therefore, the IRR of exiting quickly from company A is higher than the IRR of remaining invested, even though exit destroys value.

The problem with the IRR is that it implicitely assumes that proceeds from exiting quickly company A can be reinvested at the rate of return generated by company A in the first year. But in reality, when the PE fund returns money to its investors, their default option is to reinvest this money in the stock market, which yields a lower return.

Conclusion: Using the IRR as a performance metric leads to exiting quickly the early wins, even when doing so destroys value. The IRR can lead to inefficient decisions.

NB for skeptical readers: If you still doubting that early exit destroys value in this example, we can be calculate the NPV of exiting company A. Doing so generates an immediate gain of 90 and gives up 180 in 5 years. Valuing this cash flow using the 11% expected stock market return, the NPV of exiting is 90-180/1.115 = -17. Exiting company A has negative NPV, hence destroys value.


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