Distorting Alpha: How Omitted Inputs and Deferred Carry Can Inflate IRR Calculations (Part One of Three)

Although investors can weigh myriad criteria when evaluating PE sponsors, the most common starting point is a comparison of the internal rates of return (IRR) of PE sponsors’ past funds. While this practice should theoretically allow an apples-to-apples comparison of sponsors, it is inherently deficient because of the ways that IRR calculations can be distorted to disrupt the process. This three-part series highlights nine scenarios in which IRR figures can be distorted during the process of managing PE funds or calculating their returns for marketing purposes. The purpose of this overview is to assist general counsels and chief compliance officers in identifying these issues before they capture the SEC’s attention, while also flagging the problem for investors to enable them to more effectively evaluate PE sponsors during the fundraising process. This first article explores IRR distortions when certain fund management practices are omitted from the calculations, as well as the unintended effects of deferring carried interest for tax purposes. The second article will describe the impact of deploying subscription credit facilities, as well as the ways secondary transactions and private credit funds inherently generate inflated IRR figures. The third article will address how the curation of an investment sample (i.e., composite returns or bespoke ownership periods) can alter IRR calculations. See “Ten Risk Areas for Private Funds in 2018” (May 3, 2018); and “SEC Charges Fund of Private Equity Funds Portfolio Manager with Misleading Investors Concerning Fund Valuation and Performance” (Sep. 12, 2013).

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