Unveiling the Truth Behind Private Markets – You Won’t Believe What You Could Be Missing!

Private market funds have seen explosive growth in recent years, drawing investors with the promise of superior returns over traditional investments. However, the common practice of using the internal rate of return (IRR) as a benchmark for performance evaluations has come under scrutiny for its limitations.

In previous articles, we delved into the complexities of IRR calculations and why they fall short of painting an accurate picture of investment performance. In this final installment, we explore potential corrective measures for IRR and propose an alternative solution: NAV-to-NAV IRR.

Existing Corrections to IRR:

1. Modified IRR (MIRR) is a common corrective measure used to adjust for the limitations of traditional IRR calculations. However, the reliance on predetermined financing and reinvestment rates can still skew the results.

2. The challenges with early cash flows remain a significant issue that distorts the overall rate of return and undermines the accuracy of performance evaluations.

Proposing a Solution: NAV-to-NAV IRR:

1. An alternative approach to IRR is the NAV-to-NAV IRR, which focuses on the aggregate NAV at the beginning and end of a time period, excluding early cash flows that can misrepresent investment performance.

2. By requiring private capital firms to report a series of past returns and prohibiting the use of since-inception IRRs, the NAV-to-NAV IRR offers a more accurate reflection of long-term investment performance.

The Limits of NAV-to-NAV IRRs:

1. While NAV-to-NAV IRRs offer a more reliable performance measure, they do present some limitations, such as disregarding historical data beyond a certain threshold and the potential for biases in evaluating starting and final NAVs.

2. The quality of the starting and final NAV can significantly impact the resulting rate of return, potentially distorting the true performance of an investment.

Benchmarking Challenges:

1. Comparing private market returns to public equity benchmarks introduces complexities related to return calculations, such as geometric versus arithmetic returns and the selection of appropriate benchmark indices.

2. Strategic choices in selecting benchmark indices, such as opting for indices with lower returns, can influence the perceived performance of private market investments.

In conclusion, the reliance on IRR as the gold standard for measuring private market fund performance may not be as straightforward as it seems. By considering alternative measures like NAV-to-NAV IRR and addressing the challenges associated with benchmarking, investors can gain a more accurate understanding of investment performance and make informed decisions moving forward.