Practical analysis for investment professionals
12 October 2020

Time’s Up for the IRR: Resetting the Clock on Private Equity

The internal rate of return is dead. Long live the IRR.

“Hey, the IRR looks soooo close to the DaRC!” Michele observed.

Michele is our chief technology officer at XTAL Strategies, and I had never asked him to compute and include private equity’s internal rate of return (IRR) in our lines of code before. I had handled that. Now he was working on our new analytics dashboard, which is usually engineered exclusively on duration-adjusted return on capital (DaRC) algorithms, and noticed the similarities.

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He was shocked. He had learned since joining my team that I had developed the DaRC methodology precisely to overcome IRR’s limitations as a metric for private equity performance.

“Why develop the DaRC?” Michele asked. “It is almost identical to the IRR!” He showed me the following chart, which plots the DaRC and IRR over time, for a representative private equity fund.

DaRC vs. IRR

Line chart plotting DaRC vs. IRR

“What’s the point then?” he asked.

The point is that the DaRC is meant to be a more accurate measure that evolves the information set available to investors specifically to overcome the limitations of the IRR.

You can think of it as a “translation tool,” but it indeed is a robust performance calculation methodology that frames the same components of the IRR in the time-weighted context of all other asset classes.

The DaRC methodology, and the concept of duration, adds the critical and absent time framework to the IRR and gives an understanding of:

  1. The when, on average, the average return from the measured investments that the IRR represents starts to be earned.
  2. The how long that return is earned for.

Both pieces of information are crucial because performance numbers are useful to investors only if they help them understand how much money they’re making. An IRR of 15%, say, does not mean that investors are making 15 cents for every dollar invested in annualized terms, which is what time-weighted percentages measure.

“Okay, go on,” said Michele.

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The fact is IRR figures don’t inform investors about the two points above. In Inside Private Equity, the authors briefly introduce the concept and provide an approximation of the IRR’s net duration — the how long. Others have developed public-market equivalent (PME)-like proxy estimations of the when.

Nevertheless, without precise information about the when and the how long — and, importantly, over which time horizon — the adopted performance metrics won’t give an accurate sense of how much money investors are making (or losing) without any ambiguous approximations.

The DaRC methodology illuminates the IRR’s shortcomings. The IRR does not show that its approximate performance numbers refer to a forward-forward transaction — i.e., the cash in– and outflows happen on average at a later time than the initial subscription of commitment or the closing of the private equity fund.

To fully explain the returns, taking into account the impact of dry powder and of eventual credit and subscription lines, a precise time transfer mechanism with time stamps for the when and the how long is required. The investment horizon may be set ex ante by the interested investor if, for example, it is an expected liability situation that the investment is supposed to match.

The litmus test of the DaRC methodology’s additivity is visualized in the following table. It shows the individual and average — pooled and synthetic — performance of three investments, which could be portfolio companies or private equity funds. The DaRC, IRR, and TVPI are all calculated for a valuation date set at 31 December 2017.

Three Hypothetical Investments: DaRC, IRR, and TVPI

Table depicting returns for three hypothetical investments over varying time horizons

The top of the table includes inputs for cash flows, dates, and amounts, with negative numbers for contributions in blue, positive figures for the distributions in black. The Pooled case is simply the arithmetic sum of the cash flows of the three prior investments, while the Synthetic case is calculated using the DaRC methodology.

The DaRC methodology uses the Duration mechanism to determine the modeled Synthetic transactions: zero coupon — one bullet contribution, one bullet distribution — like in fixed income. These are equivalent to the stream of cash flows they represent. The bottom of the chart illustrates the details of the Synthetic transactions, dates, and amounts, using the same conventions of the raw data, as well as the output calculations for the DaRC, IRR, and the Horizon DaRC, or the annualized rate of return that investors can expect to earn (and actually receive) over the predetermined time horizon.

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The DaRC and IRR are indeed quite similar: They both represent the period return produced during the timespan when the capital is deployed. But just the DaRC carries along the precise timespan “ID card” information.

This ID card makes DaRC and Horizon DaRC two sides of the same coin that can be reconciled at any time — in Pooled and Synthetic form. The Synthetic model represents the Pooled sum through the duration characteristics.

How the DaRC and Horizon DaRC yields of our representative fund move over time is visualized in the chart below. The implicit difference? The DaRC is the rate of return the invested capital produces over time for the net duration — the difference of the durations of Distributions (DurD) and Contributions (DurC) — while the Horizon DaRC is the actual annualized rate of return that investors earn for the predetermined time horizons.

DaRC vs. Horizon DaRC

The Horizon DaRC then is a true yield curve where the 7% plot at the end of 2014 shown by the orange arrow is the annualized-since-inception return. It represents the actual total return yield that investors are actually receiving from the investment in the fund. The DaRC line in the chart only shows the return for the net duration as it materializes while the fund matures. Consequently, the 13.5% plot at the end of 2014 shown by the blue arrow is the DaRC recorded with the information available as of that date for the Net Duration of approximately four years (1,422 days), shown in the following table.

DurC vs. DurD

Chart comparing durations of Distributions — DurD — and Contributions -DurC

“Okay. This may require some basic math, but I get the substance,” Michele said. “What are the implications?”

It is impossible to replicate the computations above using IRRs and PMEs. Why? Because these methodologies lack additivity and time transferability properties. In fact, the non-homogeneous timeframes and notional references of cash flows they use in their calculations mean that their averages and rankings are mathematically incorrect. So IRR quartiles are essentially meaningless. Moreover, calculations based on IRR, PME, and cash flows of average returns, risk premia, alpha, and dispersion, among other variables, may have to be revised in academic studies. And finally, existing private equity indices are not accurately representing the underlying physical investments.

That’s why DaRC’s duration time stamps are critical for preserving the time-weighted value of money.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / Pavel Abramov

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About the Author(s)
Massimiliano Saccone, CFA

Massimiliano Saccone, CFA, is the founder and CEO of XTAL Strategies, a fintech SME developing a platform of innovative private market indices and risk-transfer solutions. He developed and patented a private equity performance valuation methodology, is a former member of the GIPS Alternative Strategies Working Group at CFA Institute and the author of a Guide on Alternative Investments for CFA Society Italy. Saccone has pioneering experience in the field of the retailization of alternatives at AIG Investments (now Pinebridge), a global alternative investment manager, where he was a managing director and global head of multi-alternatives strategies and, beforehand, regional head of Southern Europe. Prior to that, he was head of institutional portfolio management at Deutsche Asset Management Italy (now DWS). He is a CFA charterholder and a qualified accountant and auditor in Italy, has a master's in international finance from the Collegio Borromeo and the University of Pavia and a cum laude degree in economics from the University La Sapienza of Rome. He is also a Lieutenant of the Reserve of the Guardia di Finanza, the Italian financial law enforcement agency.

7 thoughts on “Time’s Up for the IRR: Resetting the Clock on Private Equity”

  1. MKOSHEIRY says:

    Actually, I used to apply another ratios beside the IRR, cause in case of negative cash flow the IRR will not be the right choice & will not be accurate due to more than one IRR will be existed.
    Hoping DaRC, will deal with negative cash flow.

    1. Massimiliano Saccone says:

      Hi – apologies for the slow response. You make a good point – as cash flow patterns can be unpredictable and counterintuitive. But to answer your comment, yes, the DaRC can deal with negative cash flows and always yields ONE unambiguous annualised time-weighted rate of return that anyone can reconcile with actual accounting balances (for cash or NAV).

  2. David Merkel says:

    This is a promising way to measure private equity performance. In one sense, you are evaluating private equity the way one would evaluate a portfolio of illiquid bonds that pay down irregularly.

  3. Brian K. Lee says:

    IRR is likely the single-most misunderstood financial metric. I touched on this very topic in my recent book, Advanced Discounted Cash Flow (DCF) Valuation Using R. My presumption lies in the fact it is taught incorrectly in most finance texts. Ask anyone the meaning of IRR, and you will invariably hear a recitation of the textbook definition, ‘that discount rate that causes NPV =0.’ That is absolutely not the definition of IRR. That simply explains one how it is calculated.

    The academic community has derived all sorts of ‘meaningless fixes’ to address conflict between IRR and NPV (NPV Profiles, crossover rates, MIRR, etc.).

    When a project is analyzed correctly, there is never disagreement between NPV and IRR, and it has nothing to do with MIRR. Also, the Profitability Index (PI) is a suboptimal ranking mechanism when capital is constrained.

  4. Hello, thank you for your teachings.
    Would you be so kind as to make available the Excel table – Three Hypothetical Investments: DaRC, IRR, and TVPI.
    Best regards

  5. duong trong thang says:

    there are many financial ratios such as IRR, for a company. then the company invest by buying fix asset or material, the financial ratios become worse. so, we look at competition and growth prospect before looking at the financial ratios. in other words, we consider financial ratios in context of competition and industry demand. only then, we realize the long term growth of a company. we benchmark the financial ratios of companies in the same industry to realize the differences among companies and the competitive advantages of companies

    strategic analysis come into our care at the end. strategic perspective will free us from analysis of financial ratios.

  6. Nelson says:

    Hi, how do you calculate darc and horizon darc?

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