The Horizon IRR Metric Keeps Being Misused

by Michael Roth

Accurately measuring performance and estimating asset class returns is the most important part of the asset allocation process. The reason it is important is two-fold: (1) return estimates have the biggest impact on your asset allocation model and (2) studies have shown that asset allocation is a critical component of returns.

Considering this, industry trade groups, like the BVCA, and service providers, like Cambridge Associates, continue to inappropriately tout a horizon IRR calculation in comparison to the public market’s 1,3, 5, or 10 year time weighted rate of return.

As I have discussed previously, it is a mistake to think an IRR and a time weighted return are one and the same. Both are annualized rates of return but they deal with cash inflows and outflows in different ways. IRR specifically accounts for the timing and size of cash flows when calculating the returns generated while the time weighted return specifically excludes the impact of cash flows and weights the returns in each time period equally. Each method has their shortcomings and ideal use cases. Take these metrics out of context and they can be misleading.

What difference does a return calculation make?

I used a portfolio of 481 North America and Global buyout funds from Bison’s cash flow dataset to analyze the difference between the horizon IRR and the time weighted return. Both return calculations were performed using quarterly cash flows.

Time Horizon

As you can see, the methodology you choose has a big impact on how you perceive performance. Using an IRR, private equity outperforms over the 5 and 10 year horizons. Using the time weighted return calculation, returns are lower and the portfolio underperforms over all time horizons as of December 31, 2014.

What Should The Industry Do?

  1. Use the horizon IRR properly – It can be a good measure of momentum in a fund or portfolio. When you look at the fund’s horizon IRR compared to its since inception IRR, you can tell whether the time period has had a positive or negative impact on the fund’s performance.  However, it is NOT an accurate way to compare private equity performance to public equities.                                                                                                                                                                        
  2. Use Apples to Apples Comparisons
  • Time weighted vs. Time Weighted – Time weighted returns are best used to analyze a manager’s skill against a market index (public or private). You can also use a time weighted return to evaluate the growth in total value (distributions + NAV) from quarter to quarter and compare it to a public or private market index’s quarterly growth. Used appropriately, comparing time-weighted returns can help you “take the temperature” of a fund or portfolio and determine whether it is over or underperforming the market index.
  • PME Analysis – The reason that PME analysis exists is because investors recognized that a money weighted return can not be compared to a time weighted return. PME analysis allows you to compare the opportunity cost of investing in PE vs. the public markets using the PE fund’s cash flow timing. This could be done since the inception of the fund/portfolio or for different periods of time. For this exercise, we recommend using the Bison PME IRR in tandem with the Kaplan Schoar ratio to determine whether private equity or public equity would have been a better investment.