How much of a private fund's reported IRR reaches the investor?
A fund's internal rate of return is measured on the capital the manager called; the institution's return has to be measured on the whole commitment, for the whole period it was set aside.
Only 33.3744 per cent of it, at best. Brayfield Partners reported a net internal rate of return of 13.2935 per cent over ten years against a listed index at 7.1312, an apparent advantage of 6.1624 percentage points. The 600 the Thornbury Foundation set aside on the first day of Year 1 earned 9.1878 per cent a year with the uncalled balance held in the index, and 6.2571 per cent with it held in cash. The real advantage was 2.0567 points, or none at all.
Two denominators, one programme
The Thornbury Foundation committed 600 to Brayfield Partners, thirty per cent of a 2,000 endowment, and set the money aside on the first day of Year 1. Over the following decade the manager called 564 in five instalments — 90, 150, 138, 120 and 66 — and distributed 791, beginning in Year 3. Residual net asset value at the end of Year 10 stood at 143. The reported net internal rate of return, after management fees and after carried interest, was 13.2935 per cent.
That rate is correct. It is computed on the dated flows between the fund and its investors, each weighted by the time the capital was actually outstanding. Its denominator starts at zero, rises as capital is drawn and falls as capital is returned. Money that was committed but never called never enters it at all.
The foundation's denominator is 600, from the first day to the last. The subscription agreement obliged it to produce cash within ten business days of a notice, so the uncalled balance had to sit somewhere liquid, and the returned capital landed in the same account. Net capital at work ran 90, 240, 349, 383, 306, 154, 21, −74, −160 and −227. The peak was 383, in Year 4. A commitment of 600 never had more than 383 of itself doing the thing it was committed to do, and 36.1667 per cent of it was never at work at any single moment.
The three returns, side by side
Run the sleeve as an account. Start with 600, pay out the calls, take in the distributions, credit interest at the cash rate for the year. Year 1: 600 less 90 is 510.00, and 510.00 at 0.80 per cent earns 4.08, closing at 514.08. The balance bottoms out at 226.62 at the end of Year 4, then fills up again as distributions overtake calls, reaching 957.85 at the end of Year 10 after 130.87 of interest across the decade. Add the residual 143 and the sleeve is worth 1,100.85.
Return
Capital it is measured on
Rate
Terminal value of 600
Reported net IRR of the fund
the 564 called, while it was out
13.2935%
—
Sleeve, uncalled held in the index
the whole 600, all ten years
9.1878%
1,445.08
Sleeve, uncalled held in cash
the whole 600, all ten years
6.2571%
1,100.85
The listed index
600 invested on day one
7.1312%
1,194.84
One commitment, four ways of stating what it returned. Nothing is in dispute between them.
The foundation ran the cash policy. On that policy the sleeve returned 6.2571 per cent against the index's 7.1312, so the alternatives allocation finished 0.8741 of a point a year behind the thing it was funded to beat — 1,100.85 against 1,194.84, or 93.99 of lost value, in a decade in which the manager did nothing wrong.
Where the six points went
Step
Points a year
Fund IRR to sleeve, uncalled in the index
4.1057
Sleeve in the index to sleeve in cash
2.9307
Sleeve in the index to the index itself
2.0567
The first two steps stack: 4.1057 plus 2.9307 is 7.0364, the distance from 13.2935 to 6.2571.
The first gap is idle capital, and it is the largest. It is a consequence of the instrument rather than a criticism of the manager: a fund that calls only what it can deploy is behaving well. To keep a genuine 600 at work across this schedule the committee would have had to commit 939.95, an over-commitment of 56.6580 per cent, with everything that implies for a year in which calls and drawdowns arrive together.
The second gap is a treasury decision. Held in the listed portfolio the sleeve ends at 1,445.08; held in cash, 1,100.85. The difference is 344.23 on a sleeve of 600, and it is worth 2.9307 points a year — more than the entire real advantage of the programme it exists to support. The committee spent three meetings on manager selection. The funding policy was set by whoever opened the account, and there is no paper.
The manager passed the test that was set for him. Compound every call forward at the index return and the total is 979.96; compound every distribution and the residual the same way and it is 1,230.20. The public market equivalent is 1.2554x, a direct alpha of 5.8628 per cent, and still 1.2255x against an index levered to a beta of 1.15. Selection was good and the outcome was poor, because a public market equivalent only ever sees cash that moved. The cleaner and faster the manager calls and returns, the wider the gap gets.
What to do with the number
The usual objection is the residual, and it does not survive. Sell the 143 into the secondary market at a 30 per cent discount and the index-policy sleeve still returns 8.8593 per cent, comfortably above 7.1312. A haircut of that size costs 0.3285 points; the idle capital costs 4.1057. Committee time goes to the smaller number.
Three questions make a reported private-market return readable. Is this an internal rate of return on called capital, or a return on the money set aside? Does the period start at commitment or at first drawdown? What did the undrawn balance earn, and who decided that? A manager answers the first two in a sentence; the third is the institution's own answer to give.
Then write the funding policy down before the first call notice, because after it the answer is whatever the operations desk did in the meantime. The paragraph names the listed holdings that will be sold to meet calls and in what order; sets the cash buffer against the largest plausible twelve-month call, which on this schedule is 150; states where distributions go on the day they land, since 791 comes back against 564 called and lands in the same silence; and says who may deviate, from what, and for how long. Model the return on the whole amount set aside before approving the commitment, with the funding policy stated, and recompute it every year on the actual flows. It is a ten-line spreadsheet.
The workbooks behind this article
Every figure above is a live formula in the free companion files for
Alternative Investments. Each workbook ends with a Checks sheet
setting the printed figure beside the computed one. No account and no email address.
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