It seems I’ve ruffled a few feathers with my previous post, Private equity investment private equity IRRs are misleading (lots of emails and even a few comments over at Seeking Alpha). The main point of contention is that limited partners (LPs) don’t hold committed capital as cash from day one. Someone even suggested it was ludicrous to make this assumption and that the premise of my argument collapses as a result.
However, that’s not the point I was making. Of course LPs time their cash flows across their portfolios, which is probably the reason why so many have defaulted on capital calls recently. If anything, this supports my argument rather than refutes it. So let me make my points a little clearer (I concede my last post was a little rushed):
If you hold all of the committed capital in cash from day 1, then you are exposed to the normal risk of a private equity investment. However, the private equity IRR of the investment must take into account the risk-free rate on the cash for the entire period it is held in cash (before it is called).
If you do NOT hold all of the committed capital in cash from day 1, then you increase the risk of the investment. If you default on a call, you destroy massive amounts of value (except in rare cases). Therefore, the risk you are exposed to is not just the risk of the private equity investment and hence the private equity IRR should be considered in light of the higher overall risk. Even then, any loses or gains from activities designed to meet capital calls should be accounted for in the overall private equity IRR.
I’m certainly not suggesting private equiteers are misleading LPs, but more that we all mislead ourselves through blinkered analysis. Investment private equity IRRs must be risk-weighted to mean anything and to be compared like-for-like. It’s convenient for most of us to forget the risk of default, even in the wake of the GFC when such ludicrous assumptions led to cataclysmic outcomes.