Many private equity firms are using a controversial, yet legal, approach to boost their reported performance by 25% or more, according to story by Bloomberg. These firms use short-term bank loans to reduce the time that investor money is deployed, thus dramatically boosting annual returns to investors, Bloomberg says. This comes as investors are willing to pay rich private equity management fees and as money pours into the industry, with $347 billion raised among 830 funds closed last year, bringing the industry’s assets under management to all-time high of $2.5 trillion, according another Bloomberg article. Indeed, by using the tactic in question to increase their reported returns, private equity funds can justify raising the incentive fees that they collect from investors.

Among those critical of the practice is Andrea Auerbach, head of private equity research at Boston-based investment firm Cambridge Associates LLC. She told Bloomberg, "You want to hire a manager based on how fundamentally good they are at investing, and this obscures that."

Data: Bloomberg, Preqin

Importance of IRR

The main objective of the strategy is to increase an investment's reported internal rate of return (IRR), the performance metric that private equity funds and their investors tend to focus upon the most. IRR is a measure of the compound average annual rate of return on an investment or project. IRR is a more complex calculation than compound annual growth rate (CAGR), since IRR is used to analyze investments or projects with variable cash flows (both in and out) during their lives.

Jacking Up IRR

Today buyout funds in particular face a challenge in turning impressive profits, given the soaring cost of acquisition targets, Bloomberg notes. However, they also have found an opportunity in extremely low borrowing costs. So, many of these funds complete acquisitions with financing drawn from  lines of credit, currently costing less than 3% annually, and postpone calling for investors' money as long as they can. The net result is a higher reported IRR for the transaction, Bloomberg observes in its April 13 story.

TorreyCove Capital Partners LLC, a pension consulting firm, gave Bloomberg a numeric example. Assume that a buyout fund acquires a company for $400 million, using $100 million in investors' equity plus $300 million raised through lines of credit. Also assume that the target company is sold six years later, when the value of that equity stake has doubled. Additionally, say that the $400 million purchase price is paid out in installments over the first two years. If the $100 million in equity were invested on day one, investors in the buyout fund would record a 10.6% IRR, TorreyCove calculated, according to Bloomberg. If that equity investment were delayed for two years, the investors would enjoy a 13.9% IRR, Bloomberg says. 

Investors Play Along

If you think that investors, especially sophisticated institutional investors such as pension funds and endowments, are eager to raise questions about these IRR-raising tactics, think again. It makes these institutional investors look better if they, in turn, invest in private equity funds that post higher IRRs. It also can increase their own performance-based compensation, Bloomberg says.