The Private Equity Return Gap

Research Retrieved: December 2018
Retrieve the paper from SSRN


While investors in mutual funds or hedge funds commit and withdraw funds at their own discretion, investors in private equity funds do not and can therefore not control the timing of cash flows to and from the fund. While fluctuations in the timing of cash flows of private equity funds may be the result of exogenous shocks, investment managers also have an influence. This has an effect on the internal rate of return (IRR), which is conventionally used to compare investment performance of funds. High cash distributions at an earlier time lead to an increased IRR, which provides an incentive for private equity fund managers to terminate good investments early and to pay out early dividends. The study at hand explores this issue by examining the difference between reported IRRs and the annual rates of return implied by cash-on-cash multiples among 3,915 private equity funds. The cash-on-cash multiple represents the ratio of all cash distributed to a fund’s investors during the fund’s life to all cash contributed into the fund by the investors during the fund’s life and is not affected by cash flow timing. The authors attempt to understand the causes, correlates and implications of a private equity return gap, which they define as the difference between reported IRR and the multiple-implied return.

Key Findings

  1. There is a gap between reported IRR and the rate of return implied by the cash-on-cash multiple:The authors compare actual return gaps that use reported IRRs with simulated return gaps that use the rates of return implied by the cash-on-cash multiple. Actual return gaps are significantly larger than simulated return gaps, suggesting that cash calls are on average occurring later than random during the first half of the fund’s life and that distributions are occurring earlier than random during the second half of the fund’s life.
  2. Return gaps reflect fund managers’ investment styles:Return gaps are persistent for individual private equity fund managers over funds subsequently managed funds and therefore represent investment style.
  3. Return gaps are negatively related to future multiple-implied returns:The authors decompose IRR into multiple-implied return and the return gap, in order to assess which component is more informative regarding future returns of the same private equity fund manager. They find that only multiple-implied returns, and not return gaps, are positively related to the multiple-implied returns of an investment manager’s future funds. Moreover, return gaps are negatively related to future multiple-implied returns across several fund types, suggesting that some resources are wasted on generating high IRRs.
  4. Return gaps are positively related to an investment manager’s ability to attract capital for future funds: The authors assess which IRR component is more informative regarding future fundraising on both the fund manager and the investor level. At the fund manager level, the authors find that current funds’ return gaps are positively associated with the size of follow-on funds. At the investor level, the current fund’s return gap has a positive effect on the probability that an investor reinvests with the same investment manager in a subsequent fund. Relatively less successful investors weight the return gap more heavily in their decision to reinvest in the investment manager’s subsequent fund.

Meaning for Practice

The authors state that the results of the study suggest that the limitations of the IRR as a measure of private equity returns are not fully understood by investors. The authors find return gaps of substantial size, averaging over half of the magnitude of reported IRRs. These high return gaps are negatively related to the future performance of private equity fund managers, but facilitate future fundraising, especially among certain investor types, including funds of funds, insurance companies, and private pension funds, as well as among relatively unsuccessful investors.