LPs offered new alternative to measuring IRR(2)

Good news for LPs trying to analyze the performance of a GP: performance attributable to repeatable skills and elements of performance that are out of the control of the fund managers can be split and measured separately.

This is one of the key findings in the freshly released book “New Strategies for Risk Management in Private Equity”, published by pfm’s parent company PEI and edited by alternative asset manager Capital Dynamics.

The mechanics of the performance attribution calculation, produced by Alignment Capital Group, are based on a novel property of portfolio return combined with a simple form of engineering factor analysis in which the private equity return computation is deconstructed into binary (either/or) versions of its principal cash-flow variables, weight and time.

“For prudent institutional private equity portfolio managers, it is therefore extremely important to understand the quantitative aspects of performance measurement and, in particular, of performance attribution,” said Austin Long, principal of private equity consulting firm Alignment Capital Group and one of the book’s authors.

The performance analysis can be broken down at the industry level, using data of vintages of large buyout funds, or at the manager level, with the track record of a fund group.

Being unable to quantitatively measure whether or not GPs have been riding the market when producing good returns has been a source of frustration for private equity investors. Common metrics such as money multiples (how much the invested capital is multiplied) and the internal rate of return (a performance indicator based on timing and cash flows) cannot be used to adequately measure the impact of timing on performance, according to Oliver Gottschalg, professor at the HEC School of Management in Paris.

“Do not look at IRR if you can avoid it at all,” said Gottschalg, adding that “IRR draws attention and money to the wrong fund managers.” And money multiples “ignores the question of how long it takes to multiply the money as well as the question of ‘what else could we have done with the money?’,” said Gottschalg.

Book launch – Performance attribution in private equity: At a book launch on Wednesday June 18, Jesse Reyes (J-Curve Advisors), Austin Long (Alignment Capital Group) and Morten Sorensen (Columbia Business School) will be in New York to discuss key topics of the “New Strategies for Risk Management in Private Equity” book at the Sofitel Hotel. Tickets are free; to secure yours please email kevin.b@peimedia.com.