Another Quick Lesson in Private Equity: All Returns Aren’t Created Equal
Yesterday we took at the private equity investment track record of Apollo Global Management. You’re probably hoping I’d think of something else to write about. Sorry, there’s more to the story of trying to figure out if Apollo or any other private equity firm has decent numbers. In evaluating private equity and real estate funds, we have to use something called the “Internal Rate of Return” or IRR to calculate our gain or loss. We have to use this method because the cash flows (your investment and eventual proceeds) are irregular.
|Angel Investing (2001)|
It’s not like a stock or bond investment where you make your investment and subsequently decide when to exit. In real estate and private equity, the manager decides when you need to wire money to the fund and when you get your money back. Remember, he has to find companies or real estate to buy and negotiate the purchase, and later on he has to find a seller and dispose of the company. In the course of managing a fund, you’ll be asked to wire money on multiple occasions and get capital back at various times. To calculate your return, you have to account for all those cash flows. IRR can deal with the complexities.
The problem with IRR is that it can be used to produce misleading conclusions about returns. In the hands of a money manager, the IRR can be manufactured into a great number, which in reality is a mediocre result. The best way to understand this trick is to look at two firms in the example below: Hare Asset Management (HAM) and Tortoise Investment Capital (TIC). Suppose that each firm draws $100 million from you to buy a company. A year later, HAM returns $75 million by selling a piece of the company or paying a big dividend. TIC simply manages the business. After five years, HAM and TIC both sell the investments. HAM gets $125 million, and thus has returned $200 million to you over the five-year period, while TIC generated $250 million. Nonetheless HAM is going to highlight its 25% return on the investment and proclaim its superiority over TIC, and TIC’s 20% return. By the way, we’re assuming these results are net of all fees and incentives. HAM’s gross return would have to be roughly 33%-35%, and TIC would have to generate a gross profit of close to 30%.
However, TIC made more money for you than HAM; the Tortoise beat the Hare yet again. We capture this result, by looking at the investment multiple (far right column), which is simply the total amount of money made on the investment divided by the amount of money invested. There’s a common adage in money management that states that you “can’t eat IRR.” This means that a manager can generate a huge IRR, but fail to increase the wealth of pension or endowment in a meaningful way. If a manager doesn’t generate an increase in wealth, he’s not helping to pay benefits or fund programs. When you evaluate a real estate or private equity manager, you’ve got to look at the returns and the multiple and find a good balance between the two.
What’s so misleading about the 25% return generated by HAM? The IRR formula assumes that the $75 million returned to you in year one continues to generate a 25% return. This is a highly doubtful assumption. In all likelihood, you either spent the money or committed it to other investments. For example, if you invested the $75 million in investments an average portfolio of stocks and bonds, a more realistic return on this capital would be about 17%, not 25%. The IRR formula does produce a true result for TIC as all the money was invested in the portfolio company for 5 years.
What does this have to do with Apollo? Yesterday I suggested that Apollo would emphasize the 35% gross/26% net return generated by Fund VII in marketing its latest private equity product. I described a number of reasons that you should approach these numbers with caution. Here’s one more reason. Perhaps Apollo sold some assets quickly in order to “juice” the IRR. We aren’t going to really know until many years from now when the fund is finally liquidated. Only then will it be clear if the investment multiple is consistent with the return or not. Of course, by the time you find out, you would have probably invested in Funds VIII, IX and X.