Over the past two decades, private markets have attracted substantial capital from asset owners who are convinced of their superior returns compared to public markets. This belief, however, is often built on flawed metrics and misleading narratives rather than concrete evidence. At the center of this misconception is the since-inception internal rate of return (IRR), a widely used but poorly understood performance metric in private markets.
To understand the issue, it is important to define IRR and how it differs from return on investment (ROI). IRR is the discount rate that makes the net present value (NPV) of all cash flows from an investment equal to zero. Essentially, it reflects the annualized effective rate of return based on the timing of cash inflows and outflows. ROI, on the other hand, measures the total growth of an investment by comparing the final value to the initial investment, expressed as a percentage. While ROI directly illustrates the wealth generated, IRR focuses on the efficiency of cash flow timing, which can distort perceptions of actual returns.
This distinction is at the heart of the problem. Many investors, particularly retail participants, mistakenly interpret IRR as a direct measure of investment growth, similar to ROI. This misunderstanding has perpetuated the myth of private market superiority, further amplified by success stories like the Yale model.
The Yale model, which emphasizes heavy allocation to private equity, is often cited as proof of private markets’ outperformance. Yet, this claim leans heavily on the since-inception IRR, a metric that overstates performance by prioritizing the sequence of cash flows rather than the actual wealth generated. Unlike ROI, which offers a straightforward comparison of beginning and ending values, IRR can inflate returns when cash flows are timed advantageously, obscuring the true risk-return profile of private market investments.
This reliance on since-inception IRR also creates challenges for transparency and benchmarking. The metric makes it difficult to compare private market performance with public market indices or even among private funds. Retail investors, in particular, are disadvantaged, as they often lack the expertise to critically analyze these complex metrics.
A practical alternative exists: horizon IRRs. Horizon IRRs evaluate performance over a fixed period, offering a clearer and more comparable view of returns across both private and public markets. By focusing on consistent timeframes, horizon IRRs mitigate the distortions caused by cash flow timing, aligning reported performance more closely with economic reality.
The need for change is urgent. Regulators or industry bodies should mandate the adoption of horizon IRRs to enhance transparency and comparability in private market reporting. By doing so, investors would gain access to tools that allow for more informed decisions, fostering greater trust and accountability within the private capital industry.
Adopting more robust performance metrics is not merely a technical adjustment; it is a necessary step toward sustainable growth in private markets. With greater transparency, asset owners can better evaluate the true potential of private investments, ensuring capital allocation decisions are based on reality rather than illusion.
