Net of Fees Performance Figures

Last year, the U.S. Securities and Exchange Commission looked at how many private equity firms calculate net of fees internal rates of return for their funds. The focus was on whether the performance figures disclosed if general partner investments are included in or excluded from that calculation.

General partners in a private equity fund typically do not pay management or incentive fees. So if the general partner’s capital is included in the net of fees IRR calculation, the net IRR returns would be higher than if that capital was excluded.

I think this distortion will be largely limited to situations where general partner capital is a large percentage of fund assets. One aspect is that calculation of fees in private funds is not tightly regulated as it is for mutual funds. Different strategies will require managers to sho performance in different ways.

Private equity funds have a particularly difficult time with net IRR calculations for funds that are not fully realized. The fees keep tolling as the fund continues through its life-cycle and underlying investments are realized. A fund manager cannot show the net of fees return for a particular realized investment because the standard management fee is not tied to the investment itself, but instead to the life of the private equity fund.

The concern is always that net IRR returns for such funds should not mislead prospective investors. That means inserting adequate disclosure regarding the net IRR calculation methodology.

The SEC has stated that performance should be what a typical investor will experience. A private equity fund manager should construct and show its performance as a typical investor would have its investment perform.
Sources:

• SEC probing private equity performance figures by Greg Roumeliotis in Reuters
• SEC Probing Private Equity Firms’ Net of Fees Performance Figures by ACA Compliance