IRR vs Return on Committed Capital
Typically, venture capital and private equity firms will report their returns as the Internal Rate of Return (IRR). The problem with this measure is that it doesn’t represent the returns that the investors will receive on their committed capital over the life of the fund.
The IRR is effectively the return on funds as drawn. To understand this a little better, I’ve included the calculation below, which solves for the IRR based on when the cash flows are received — generally outflows [negative] at the beginning with a bullet payment [positive] to the investor at the end:
The IRR doesn’t take into consideration the return on the committed capital (total capital that’s committed at the inception of the fund). A measure of the Return on Committed Capital (ROCC) could be a better measure of a fund’s success than looking at the IRR because it allocates some time-value to the funds which have been set aside before they’re deployed.
Capital calls
Investors (or limited partners) in venture capital or private equity funds will set aside a majority of the committed capital at inception. Investors will have up to (and generally significantly less than) 30 days to wire their funds to the fund manager once they receive a capital call. This means that they will need to have a sufficient amount of liquidity available to meet capital calls whenever they show up. Having this liquidity incurs a cost that isn’t taken into consideration in the calculation of the IRR.
This isn’t the only tension that occurs with traditional venture capital and private equity funds, there’s also the race to deploy capital. Now you’re probably thinking, “Why would a fund want to deploy the capital as quickly as possible and not just focus on the “best” opportunities?”
The Investment Period
Typically, the management fee moves from being calculated based on the “committed capital” over the investment period (typically the first 5–7 years) to the “invested capital” during the harvesting period (the balance of the fund life). This means that if a fund doesn’t deploy all of its committed capital over the investment period then it will suffer a drop off in management fees. The management fees are used to operate the business.
To avoid this drop in management fees, the fund manager will generally attempt to deploy all of the committed capital during the investment period. This will cause the “hurdle rate” and cognitive effort that the manager puts into a deal to drop as it gets closer to the end of the investment period.
IRR vs ROCC example
Now, to explain what this all means to the IRR vs the ROCC. Assume that a fund manager was able to generate an IRR of 55% on their portfolio previously. If instead, of counting the return from the date that the capital was drawn, the counting begins on the date that the capital is committed the ROCC would be closer to 30%. The ROCC is almost half that of the IRR. However, the discrepancy between these numbers illustrates that IRRs don’t tell the whole story and investors might not be getting what they’re signing up for.
The solution
Funds should report both metrics if the investors. There will be some situations where investors have some flexibility over their cash management so they will be able to determine which metric is the most appropriate. The IRR only tells half of the story.
