Has Covid-19 made IRR an irrelevant measure of success?

How has the pandemic affected the internal rate of return (IRR) of funds? It's a question that will be at the forefront of the minds of investors, who have return targets to achieve and compare funds based on their IRR performance, and of fund managers, whose financial rewards are reliant on clearing an IRR hurdle.

But how many of those investors and managers really understand how IRRs work? What will be the true impact of Covid-19 on fund IRRs? And is there a better metric for assessing fund financial performance?

Not annual returns

The IRR has become the yardstick for private investment managers and their investors, but the calculation has significant limitations that managers and investors need to understand. However, an IRR is not the same as an annual return. To assume that by achieving an 8% IRR an investor's equity has increased by 8% on an annualised and compounded basis is incorrect. An IRR is an annualised rate of return that takes into account the timing of cash flows and assumes that all distributions will be reinvested immediately at the same rate of return.

An IRR calculation is seen by many as being more accurate than an annualised return because it reflects when money is drawn into funds, and when it is distributed by them – it takes into account the timing of cash flows, even if money is invested for short periods.

Compounding complexities

On the face of it, the IRR calculation is easy – Excel will do it for you – but it is more complex than it seems. Because it assumes that all distributions will be reinvested immediately, there is a built-in compounding assumption that may not happen. Irregular positive and negative cash flows can also affect a simple IRR calculation, in some cases producing more than one IRR.

Why is this important? For investors it means that two funds can produce the same IRR but can have wildly different cash flow profiles and can generate very different total gains on invested equity (or multiple). By way of a simple example, both of these funds produce a 15% IRR:

This might suggest that Fund 2 is the "better" fund – it produces the same IRR and has a higher equity multiple. However, in the first fund the investor is getting their money back sooner rather than later and in a less lumpy manner, giving the investor more chance to reinvest that money at a good rate of return. This supports the inherent IRR assumption that the distribution is reinvested at the same rate of return.

In the second fund, to achieve the same IRR, the fund manager needs to drive up cash flows later in the fund's life. This could be achieved by refinancing assets, using an equity bridge facility or making riskier investments. While this achieves the necessary IRR and generates a better multiple, it pre-supposes, for the IRR assumption in relation to re-investment to be correct, that the investor can reinvest the future distributions it receives at the in-year rate of return. Given the timing and amount of the distribution this is less likely to be the case than with earlier, smoothed distributions.

Covid-19 effect

Covid-19 has had a marked impact on private funds, with most suffering distribution shortfalls. While this has been more significant in some asset classes, such as real estate, across the industry fund managers are contemplating depressed IRRs and, with that, lower carried interest amounts. This is prompting managers and investors to reflect on what they need to get back to their target IRR. This could be achieved by taking greater risk or extending the life of the fund, as shown below:

Both funds achieve a 15% IRR but in different ways. Fund 1 extends its life and makes a cautious return to investing. Fund 2 aggressively refinances and returns money to investors, but then runs into difficulties. Although the IRR is the same, Fund 1 generates a 1.45 equity multiple, whereas for Fund 2 the equity multiple is only 1.35 (and with significantly more risk). In both scenarios the fund manager achieves the same IRR return (and potentially, therefore, carried interest), but the investor does significantly better in Fund 1.

A better way to assess performance?

The issue that these scenarios illustrate is not just driven by Covid-19. While IRR and annualised returns may appear to be same, they are not. Even if a fund produces a high IRR it might not generate any real wealth. Conversely, a fund that generates a lower IRR may, depending on the timing of cash flows, generate a far more attractive total return or multiple on equity.

As investors and managers look at the impact of Covid-19 on IRRs, and, perhaps, before any decisions are made about whether the IRR in the fund documentation or the associated business plan is achievable or may need to be revisited, both parties should ask themselves what they are really trying to achieve. Now may well be the time to consider whether the IRR and the equity multiple are appropriate measures of success and fund waterfalls reflect those dual measures. This is relevant not just for funds living through Covid-19, but also for those conceived in its aftermath.