Study: ‘money multiple and IRR too simplistic’

Good news for LPs trying to correctly predict the future performance of a GP: alpha, the excess return that a fund manager achieves compared to investments on the stock market, can give a much clearer idea than the traditional money multiple and IRR, according to a new study.

The study by German-based fund of funds manager Golding Capital Partners and the HEC School of Management, detected “a statistically significant correlation” between an excess return compared to stock market investments in the past and in the future.

GPs that generated an above-average alpha in the past are highly likely to also achieve an above-average alpha in future, according to the study which looked at more than 5,600 realized private equity transactions between 1977 and 2014 from Golding’s database.

By taking alpha into account, investors can significantly increase their expected portfolio returns if they only invest in fund managers that have been in the top quartile in terms of alpha in the past. Selecting managers by looking at alpha could lift the average portfolio return by 600 basis points, the study claimed.

“That should be a relatively convincing argument for the industry to make better efforts to move to a better performance measure,” Oliver Gottschalg, professor at the HEC School of Management in Paris and one of the study's authors, said during a conference call on Tuesday.

He warned that money multiples – how much the invested capital is multiplied, and the internal rate of return (IRR), a performance indicator based on timing and cash flows, cannot be used to adequately measure performance persistence.

“Do not look at IRR if you can avoid it at all,” Gottschalg said. “IRR distorts the ranking in terms of quartiles, IRR does not persist, IRR draws attention and money to the wrong fund managers.”

While the money multiple is “not as problematic as the IRR”, it still has limitations, he argued. “It ignores the question of how long it takes to multiply the money [and] it ignores the question – ‘what else could we have done with the money?’ Alpha precisely considers those two things. It’s an annualised measure; it considers only value creation in excess of the public market swings,” he said, adding that the IRR and money multiple are “too simplistic to measure private equity”.

Looking at the absolute return performance indicators of predecessor funds is only helpful to a limited extent, Jeremy Golding, founder of Golding, added. “Private equity investors would be well advised to select fund managers whose performance has an above-average alpha and therefore allows for conclusions to be drawn about the persistence of their investment success.”

The study also provided evidence about the persistence of specific risk performance indicators and the holding period of portfolio companies. This revealed a significant correlation between the previous and subsequent period with the holding period, portfolio loss ratio, and return distributions of individual fund managers.

Additionally, the private equity transactions that were included in the study generated an average positive alpha of 8.6 percent over the comparable return from the stock market. Private equity was also able to show a very stable performance throughout the crisis, with investments active during the collapse of Lehman Brothers generating a positive alpha of 3.3 percent, the study claimed.