As you may have seen, on October 29th Reuters reported that the U.S. Securities and Exchange Commission (SEC) is examining how private equity firms calculate net of fees internal rates of return (IRR) for their funds, and whether they disclose if general partner investments are included in or excluded from that calculation.
As noted in the Reuters article, private equity firms use different methodologies relating to general partner capital (GP capital) when calculating net IRR. Because general partners in a private equity fund typically do not pay management or incentive fees, if GP capital is included in the net of fees IRR calculation, the resulting net IRR returns will be higher than if GP capital was excluded. The article suggests that the SEC may be concerned about situations where GP capital comprises a large percentage of fund assets, because net IRR returns for such funds could potentially mislead prospective investors unless accompanied by adequate disclosure regarding the net IRR calculation methodology.
ACA has significant experience working with private equity managers on the calculation of net IRR returns for their funds. In our experience, managers typically employ one of two approaches, the "actual method" and the "original investor method." Firms that use the actual method calculate the net IRR for the fund using all assets under management within the fund, including GP capital. When using the actual method, firms should disclose that the net of fees performance returns include GP capital (as well as any other classes of fund investors that pay reduced fees) and the percentage of assets in the fund that are not subject to management and incentive fees. In addition, firms should disclose that performance returns representative of a full fee paying original investor are available upon request.
Firms that use the original investor method calculate the net IRR for the fund using an original, full fee paying investor in the fund. This method is often viewed as more useful from an investor's perspective, as it reflects what an investor would have achieved for performance had they been invested in the fund since inception. When using the original investor method, firms should disclose that the net of fees IRR for the fund was calculated using a representative investor and does not include GP capital in the calculation and that the representative investor’s experience may not be representative of other investors in the fund. Firms using this method also should be mindful of disclosing the basis for other ratios and multiples presented alongside performance returns, such as the multiple of invested capital (MIC), and whether or not GP capital is included in such calculations.
Current regulatory guidance does not prohibit the practice of presenting net of fees performance returns that include GP capital. However, if a firm chooses to include GP capital in net IRR computations, it should be careful to disclose that this approach was taken.
In light of the SEC's scrutiny of performance returns of private equity firms, ACA recommends that firms perform a detailed review of their calculation methodologies and procedures to ensure that such methodologies align with disclosures accompanying the firm’s performance returns.
Given the inherent complexities in IRR calculations, especially relating to net of fees performance calculations, ACA offers a Focused Performance Review service tailored to private equity firms. Our Focused Performance Review service is designed to provide additional assurance to firms regarding their performance track record and accompanying disclosures.
If you have questions on this topic or would like more information on ourFocused Performance Review service, please contact:
Christie Dillard Horsman