Last month I had the opportunity to moderate a panel at the PEI CFOs & COOs Forum in New York on “Performance Calculations: Does the PE Industry Need More Standardization?” The panelists were seasoned CFOs from respected private equity fund managers and exchanged engaging dialogue with over 100 attendees in the breakout discussion.
The panel spent the majority of the discussion covering the following areas:
- Subscription lines of credit;
- Recallable capital;
- Net of fees return methodologies;
- Benchmarking PE returns; and
- Standardization in the future.
The use of subscription lines has increased substantially in recent years. What we observed through discussion and polling was that sublines are now utilized for longer time periods as opposed to simple bridge financing, which effectively works as a form of leverage for purposes of fund IRRs.
This area is a clear risk for firms from a regulatory perspective when marketing fund performance during capital raise periods; the need for clear disclosure on the extent and usage of sub lines is critical. Some poll participants noted that their CCOs prefer disclosing IRR performance inclusive and exclusive of the effect of sublines for full transparency, which delay capital calls from investors.
There was quite a bit of divergence amongst the group when polled about the treatment of recallable capital when calculating MOIC. Including recallable capital as an additional capital call in the denominator vs excluding it can cause quite a bit of distortion in the MOIC; attendees were evenly split on the use of the two methods for calculation. From an investor’s perspective, having one widely accepted standard for treatment of recallable capital would be ideal, but short of regulator or investor demand for consistency, I expect to see continued diverging approaches going forward.
Similarly, attendees were evenly split when asked how they treat GP capital in the fund IRR calculation. Including GP capital effectively increases the fund IRR relative to the IRR that a full fee-paying investor would receive, considering GP capital is typically subject to no management and incentive fees. This has minimal impact on the fund IRR when GP capital is a small portion of the total fund, but it can have a material, inflationary, effect when GP capital starts to exceed 15-20% of the total fund. CCOs should pay particular attention to this item, understand the methodologies in place, evaluate the materiality of the chosen method, and ensure prominent and clear disclosure of the chosen method for each fund IRR presented is available.
Benchmarking fund returns against an index is the norm for traditional investment strategies, but is challenging in the private equity industry with no industry standard in place. Our discussion revealed that many managers do attempt to use peer group-type indexes, such as those calculated by Cambridge, to compare to fund performance. One of the main issues discussed with vintage year indexes is the challenge in comparing indexes with fund performance when substantial use of sublines exist.
Increased requests from investors for public market equivalent (“PME”)-type benchmark comparisons were also noted during the discussion. These comparisons effectively attempt to take the cash flows of the fund and simulate what the return would have been if money had been invested at the same times and same amounts in a public index instead of the fund (i.e., the S&P 500). Other than the increased requests for PME-type comparisons, I personally do not see consistent approaches going forward with respect to benchmarking PE fund performance.
The discussion ended with a question to the panel on what it might take to standardize performance reporting in the PE market. Clearly, standardization would be great for investors, and equally for managers, at least from the CFO’s perspective, but the panel and the audience all shared the theme that consistency will likely not occur until investors or regulators force change. The GIPS® Standards would likely be a good starting point for consistency but would have to be investor-driven. Short of this, CCOs need to pay particular attention to understanding the methodologies, calculations, and supporting disclosures used in fund reporting to ensure performance presented is fairly represented and clearly disclosed.
For questions, please contact Justin Guthrie at (866) 279-0750.
Join us for a complimentary roundtable “Performance Reporting Challenges for Private Equity” focusing on controls and risk as it relates to calculating and reporting performance for private equity investment through closed-end fund structures.
Thursday, February 15, 9 a.m. to 11 a.m. in New York: Register here
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About the Author
Justin S. Guthrie, CFA, is a partner at ACA Performance Services, a division of ACA Compliance Group. His primary responsibilities include serving as a partner on traditional and alternative performance engagements.