In their study, What Do Private Equity Firms Say They Do?, academics Paul Gompers, Steven N. Kaplan and Vladimir Mukharlyamov provide insight into private equity fund managers’ approach to determining capital structure, valuing transactions, sourcing deals, governance and operational engineering.
The study surveys 79 private equity general partners (with a total of $750 billion of private equity assets under management) and ultimately concludes that few private equity investors rely on cash flow or net present value to calculate performance, and instead rely on internal rates of return and multiples of invested capital as basic performance metrics. According to the study, this is due, in part, to the fact that private equity GPs believe that their LPs are more focused on absolute performance rather than relative performance or alphas.
Moreover, the study finds that firms use different factors to calculate IRRs, implying that IRRs falls short in providing a true metric by which to compare PE firms with one another. The diversity of criteria factored into a private equity firm’s gross IRR calculation means that hurdle rates are also likely to vary significantly for similar investments.
Fortunately, there exists a full spectrum of sophisticated performance analysis products developed by PERACS that effectively evaluate returns, identify top quartile managers, highlight performance repeatability, and allow for accurate firm-to-firm comparisons.