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Private equity funds are the widely accepted investment strategy for pensions, endowments, family offices, and other investors to access the private markets. But the reported ‘returns’ of PE funds are misleading, representing only a partial view of the capital involved. 

Typically, private equity fund returns are shown for deployed capital, which can persuade limited partners (LPs) that a fund's returns are higher than reality — up to 50% higher, in fact. By carefully considering a fund investment from an LP’s perspective, we can first understand what reported returns do mean and then build more holistic picture to appreciate the overstatement. 

Sitting on the LP side of the table, what does it mean to "invest in a PE fund"? Legally, an investor will sign a Limited Partnership Agreement stating their obligation to provide capital for future investments. A large figure is committed to the fund up front and an LP naturally treats that commitment as a portfolio allocation to private equity. 

Two inaccuracies in Preqin's 22% IRR number

In return, according to Preqin's 2016 PE Report, the top quartile of funds deliver a 22% IRR (and what fund admits to being outside the top quartile?). 

Two inaccuracies exist with this 22% number: one an assumption and the other an omission. 

The assumption is, as Harvard Business Review points out, the IRR is calculated on a cash-flow basis. With that analysis, reported IRRs imply that cash distributions from selling investments are reinvested at the same IRR over the entire investment period. That's untrue unless LPs can deploy capital from PE investments immediately into equally profitable opportunities immediately as funds are distributed. 

The omission, a piece missing entirely from funds' calculations, is the hidden but considerable opportunity cost of committed capital. 

Continue reading the full analysis on Harvest:

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