“You can’t see the actual performance of a fund until it sells out after 10 years, so you rely on what the general partner says that the companies in that fund are worth,” Eileen said. Appelbaum, co-director of the Center for Economic and Policy Research, who has written extensively on private equity.
Longtime critics like Ms. Appelbaum and Mr. Phalippou say the typical methodology used to communicate results to investors, known as the internal rate of return, or IRR, is easy to play with.
“It is certainly very misleading,” Phalippou said.
But, said Appelbaum, “the private equity guys love it.” For example, she said, if a 10-year private equity fund buys 10 companies and decides to sell the best one early on, the IRR is great.
“You got a lot of money when you sold it, so you have a really high rate of return,” she said. This is because the IRR assumes that until the fund is liquidated, the profit from that sale can be reinvested at the same high rate.
The IRR methodology may be the reason some funds look better in their early years, especially if they have borrowed money to add to investments – a growing trend. Cambridge Associates, an investment and advisory firm, estimates that these borrowings, which are essentially short-term loans called subscription lines, can boost returns by up to three percentage points.
The Blackstone Total Alternative Solutions funds, which contain buyout, credit, real estate and growth strategies, provide an interesting overview. According to internal marketing materials reviewed by the New York Times, BTAS 2014, the first fund in the series, had a net IRR of 7.7% in March, after calling 84% of its investor capital. But BTAS V, which launched in January 2019 and had only called up 51% of its capital, posted a much higher net IRR – 42.9%.
A spokesperson for Blackstone said those performance numbers were “handpicked and misleading numbers for our BTAS program, which has generated 16% net returns since its inception in 2014.”