2006 07 12 You Cant Eat Irr

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: You Can’t Eat IRR Until rather recently – certainly up to the early 1980s – “investing” was largely synonymous with “stocks and bonds.” And the performance of a stoc k or bond portfolio was evaluated in terms of its rate of return. You invested a certain am ount of capital, and the percentage by which it increased in a given year was its annual return. To quantify performance over a multi-year period, you chained the individual yearly returns to come up with a compound annual return: Annual Return Dollar Gain Portfolio Value Initial Investment $1,000 Year 1 10% $100 1,100 Year 2 15 165 1,265 Year 3 8 101 1,366 Comp. Ann. Return 11% But in the last few decades, buyout and ventur e capital funds came along, changing things. Funds like these start with capital commitments , call and invest their capital over time, and thereafter manage and liquidate their portfolios. They expand and contract radically, and in assessing their performan ce, it’s clear that a given year’s percentage return matters more – and thus should be given more weight – if it was achieved when the fund held a lot of capital (and less if it was not). Investors wisely concluded that the performance of such funds should be assessed using a measure capable of capturing this phenomenon. They turned to “i nternal rate of return,” the now-ubiquitous “IRR,” as the yardstick with wh ich to measure results for portfolios that experience significant cash inflows and outflows. In mathematical terms, IRR is the discount rate that sets a fund’s cash outflows equal to its inflows in present value terms. In other word s, you list all of the fund’s contributions and distributions and solve for the discount rate that makes them add up to zero. If discounting at 20% accomplishes this, then the amounts received in distributions represent an average advance of 20% per year over the capital contri buted, and that’s the fund’s IRR. I’ll provide a simple example on th e next page to illustrate the difference that can arise between compound annual return and IRR. © Oaktree Capital Management, L.P. All Rights Reserved Fund A Annual Return Dollar Gain Distribution Portfolio Value Initial Investment $1,000 Year 1 10% $100 $600 500 Year 2 40 200 650 50 Year 3 100 50 100 -- Comp. Ann. Return 45% IRR 21 % The 10% gain in year one, achieved on star ting capital of $1,000, produced a $100 gain in the fund’s value. The 100% return in year three, on the other hand, was applied to just $50 of capital, producing a gain of $50. Although the percentage return was much higher in year three, it produced just half the dollar gain as the smalle r return in year one. Thus, in calculating the fund’s overall performance, the 100% return should be accorded much less weight than the 10% return. IRR produces that result (wher eas compound annual return does not). Because a given year’s annual resu lt is weighted in the IRR calc ulation by the number of dollars in the fund that year, and thus counts for more wh en the fund is larger an d less when it’s smaller, internal rate of return is referred to as a “dolla r-weighted” return. To make the distinction clear, the old compound annual return is now referred to as a “time-weighted” return. This nonsensical term means that every year’s individual return is given the same weight in the calculation. It’s the same as saying “equal-weighted,” or even “unweighted” . . . but “time-weighted” sounds much more scientific. (It’s not for nothing th at George Bernard Shaw defined professions as “conspiracies against the laity.”) For Fund A, shown above, the three-year IRR is 21% . This is far more reflective of the amount of wealth created than is the 45% time-weighted return. The di fference arises because the IRR calculation gives relatively little weight to the 100% re turn achieved in the third year, whereas the time-weighted return gives it as much we ight as the first-year gain of 10%. To fully understand the importance of this distin ction, consider Fund B, which achieves the same annual returns as Fund A – and thus the same compound annual return – but holds on to all of its capital through the end of the third year. Fund B Annual Return Dollar Gain Distribution Portfolio Value Initial Investment $1,000 Year 1 10% $ 100 0 1,100 Year 2 40 440 0 1,540 Year 3 100 1,540 $3,080 -- Comp. Ann. Return 45% IRR 45 © Oaktree Capital Management, L.P. All Rights Reserved The annual returns are the same for Fund B as for Fund A (and thus so is the three-year compound annual return). But Fund B’s IRR is 45% (the same as its compound annual return, since there weren’t any interim inflows or outflows), while Fund A’s is 21%. The difference arises because Fund B achieved its 100% return in year three with beginning capital of $1,540, as compared with just $50 for Fund A. Fund B produced total distributions of $3,080, while Fund A’s distributions totaled only $1,350. Certainly Fund B’s performance should be considered superior – even though the two funds’ time-weighted returns are the same. Fund B’s superiority is captured by its higher IRR. UBig Percentage Gains on Small Dollars – Real-Life Example #1 I would find it hard to invent examples as extreme as some of those provided by real life. Let’s look at the results for our first distressed debt fund – Special Credits Fund I – in 1996, its last year in business. This fund was formed in October 1988 with committed capital of $96.5 million, which was fully drawn and invested by the end of 1990. It achie ved annual before-fee returns ranging between 29% and 89% in 1991-94 and made large distribu tions in 1992-93. By the end of 1995, its since- inception time-weighted return had reached 23.7%, its IRR stood at 24.0%, and it was down to one asset carried on the books at $1.9 m illion. So far, a simple picture. In the first few weeks of 1996, that sole remaining asset was sold for more than $10 million. On the strength of that sale, the fund reported a 579.1% annual return for 1996. This high annual return (and the very brief period of time it t ook to achieve it) had th e effect of doubling the fund’s time-weighted return from 23.7% at the end of 1995 to 46.9% in 1996. And yet, the $8 million profit realiz ed on the sale of that last a sset added just 8% to the fund’s total dollar gain, bringing it to $104 million. Prop erly, the effect on the fund’s cumulative IRR of this small-dollar, high-percentage gain wa s limited to lifting it just from 24.0% at the beginning of 1996 to 25.5% at the end. It goes without saying that, if relied on, the time- weighted return of 46.9% would have presente d a highly distorted pi cture of this fund’s achievements. IRR is much better than time-weighted returns because it isn’t fooled by high percentage returns achieved w ith little capital invested. Time-weighted returns are irrelevant for evalua ting the performance of private equity-type funds. IRR is the answer. Or is it? UIRR’s Limitations The good news is that internal rate of return is infinitely better th an time-weighted return as a tool with which to evaluate the performance of funds that expand and contract. The bad news is that IRR is far from perfect, fa r from sufficient, and relied on far too much. Most of IRR’s shortcomings surround the very ph enomena it is designed to capture: inflows and outflows. Because private equity funds can expand and contract at widely varying rates, IRR can’t tell the whole story. IRR shows how good a job the manager did with the capital he © Oaktree Capital Management, L.P. All Rights Reserved 4employed. But it doesn’t tell you anything, for example, about how promptly he put the capital to work. Here are the results for two funds, both of which have committed capital of $1,000: Fund X Fund Y Year Capital Call Jan. 1 Invested Capital Jan. 1 Annual Return (%) Dollar Gain 12/31 Value Capital Call Jan. 1 Invested Capital Jan. 1 Annual Return (%) Dollar Gain 12/31 Value 1 $100 $ 100 10% $ 10 $ 110 $10 $ 10 10% $ 1 $ 11 2 200 310 20 62 372 20 31 20 6 37 3 300 672 30 202 874 30 67 30 20 87 4 400 1,274 40 510 1,784 40 127 40 51 178 $784 $78 IRR 31% 31% Because they both made capital calls at the same time and in the same proportions, and they both achieved the same annual returns on their invest ed capital, Fund X and Fund Y show the same IRR. But Fund X racked up dollar gains tota ling $784 on its $1,000 capital commitment, while Fund Y’s gains totaled just $78. Even though they had the same IRR, no one would say they performed equally well. Fund X called down all of its capital and invested it profitably, while Fund Y called down and invested only a tenth of it s capital. The process through which IRRs are calculated is oblivious to that important difference, since its only inputs are fund contributions and distributions. The manager of Fund X got the money to work much faster than Fund Y and produced $704 more of gains on the same $1,000 capital commitment. If two funds can produce the same IRR but such different total profits, I RR simply can’t be a perfect yardstick . Clearly, the ability of a manager to put capi tal to work both profitably Uand U promptly has to matter. How about funds X and Z? (The data is the same as in the table above, other than the fact that each of Fund Z’s annual returns has been increas ed by ten percentage points versus Fund Y.) Fund X Fund Z Year Capital Call Jan. 1 Invested Capital Jan. 1 Annual Return (%) Dollar Gain 12/31 Value Capital Call Jan. 1 Invested Capital Jan. 1 Annual Return (%) Dollar Gain 12/31 Value 1 $100 $ 100 10% $ 10 $ 110 $10 $ 10 20% $ 2 $ 12 2 200 310 20 62 372 20 32 30 10 42 3 300 672 30 202 874 30 72 40 29 101 4 400 1,274 40 510 1,784 40 141 50 70 211 $784 $111 IRR 31% 41% © Oaktree Capital Management, L.P. All Rights Reserved Now Fund Z’s IRR isn’t the same as Fund X’s – it’s higher. But Fund Z produced dollar gains totaling just $111, while Fund X’s ga ins total $782. Fund X – with the lower IRR – has to have done the better job. Again, evaluation based solely on IRR proves clearly inadequate. UThe Answer (Maybe): Times-Capital-Returned Because of the shortcomings of IRR – primarily th e fact that it tells you what the return was on the capital employed but not how much capital was actually employed – people seeking to measure fund performance have come up with an alternative meas urement: times-capital- returned, or TCR (that’s my name for it; there are lots of others). Whereas the calculation of IRR is complicated, for TCR it’s simple: How much did you commit to the fund, and how much did it return? If you commit $1 m illion to a fund and receive distributions totaling $2 million over its life, its times-capital-returned is 2. TCR solves IRR’s problem with undrawn capital. Looking at the table on page 4, Fund X’s TCR is 1.78 (ending value of $1,784 divided by committ ed capital of $1,000), and Fund Y’s TCR is 1.08 ($1,078 – the total of the ending value of $178 and the uncalled capital of $900 – divided by committed capital of $1,000). The difference between the two TCR ratios reflects the fact that even though the two funds earned the same return on the money they managed to invest, Fund X did a far better job of putting its capital to work. Before proceeding, it’s importan t to note that there is cons iderable unevenness in the way profitability ratios are calculated. Some people don’t look at th e ratio of ending value to committed capital, but rather at the ratio of ending value to contributed capital or invested cost, sometimes called a “multiple of cost.” I consider this highly inappr opriate, as it tells you how much was earned on the capital that was invested but does not deal at all with the fact that capital went undrawn (and as such it shares IRR’s great shortcoming). Certainly managers should be held responsible if they fail to prompt ly invest the capital commitments they accept. Multiples based on investment rather than commitment don’t accomplish this. Let’s calculate the multiple of cost – the ratio of ending value to contributed capital – to the data for Funds X and Y shown on page 4. Fund X’ s ratio is 1.78 ($1,784 divided by $1,000). So is Fund Y’s ($178 divided by $100). But who doesn’t think Fund X did the better job? As opposed to a fund that calls down 10% of its committed capital and achieves a high IRR and multiple of cost, a limited partner would probably prefer a fund that draws down all of its capital and earns even a somewhat lower IRR and multiple of cost. Of course, this ultimately depends on how the limited partner feels about having cap ital uncalled, and on what he does with it while it is uncalled. Times-capital-returned (in which committed capita l is the divisor) is much better than IRR in that it takes into consideration both how much of the committed capital was called Uand U the return that was earned on it. © Oaktree Capital Management, L.P. All Rights Reserved Unfortunately, times- capital-returned isn’t perfect either. Simply by holding on to its capital long enough, a low-return fund can produce a high er TCR than a high-return fund. But it may not have done the better job. Let’s consider two more funds: L and M, each with committed capital of $1,000. Fund L calls all of its capital and ea rns 20% per year for four years (t urning the $1,000 into $2,074). Fund M also calls all of its capital, and earns a return of 5% per year, but it goes fifteen years without selling an asset or making a distribution. In this way, Fund M turns its $1,000 into $2,079. According to TCR, they performed the same. But in order to turn $1,000 into $2,070, would you rather give up the use of your money for four y ears or fifteen? I’d rather be in Fund L. UHow Should Performance Be Judged: IRR or TCR? In comparing two funds, if one has a higher inte rnal rate of return and a higher times-capital- returned, certainly it di d the better job. Fund G Fund H Year Capital Call Jan. 1 Invested Capital Jan. 1 Annual Return (%) Dollar Gain 12/31 Value Capital Call Jan. 1 Invested Capital Jan. 1 Annual Return (%) Dollar Gain 12/31 Value 1 $300 $ 300 10% $ 30 $ 330 $300 $ 300 10% $ 30 $ 330 2 700 1,030 20 206 1,236 700 1,030 20 206 1,236 3 0 1,236 30 371 1,607 -400 836 30 251 1,087 4 0 1,607 40 643 2,250 -400 687 40 275 962 $1,250 $762 IRR 28% 25% TCR 2.25 1.76 Although Funds G and H had the same annual retu rns, Fund G’s IRR is higher because it had more money invested in high-re turn years three and four. Th at gave it a higher TCR, at 2.25 (ending value of $2,250 divided by $1,000) as op posed to Fund H’s 1.76 (ending value of $962 plus $800 returned, divided by $1,000), as well as a higher IRR. With both a higher IRR and a higher TCR, it’s easy to see that Fund G did better. But it’s possible for one fund to have the higher IRR and the other the higher TCR. In the following comparison, the two funds drew down their capital at the same rate and again had the same annual returns, but Fund J held on to its as sets while its returns declined, whereas Fund K made significant distributions at the beginning of years three and four. © Oaktree Capital Management, L.P. All Rights Reserved Fund J Fund K Year Capital Call Jan. 1 Invested Capital Jan. 1 Annual Return (%) Dollar Gain 12/31 Value Capital Call Jan. 1 Invested Capital Jan. 1 Annual Return (%) Dollar Gain 12/31 Value 1 $300 $ 300 30% $ 90 $ 390 $300 $ 300 30% $ 90 $ 390 2 700 1,090 20 218 1,308 700 1,090 20 218 1,308 3 -- 1,308 10 131 1,439 -400 908 10 91 999 4 -- 1,439 5 72 1,511 -400 599 5 30 629 $511 $429 IRR 13% 16% TCR 1.51 1.43 Because Fund J didn’t make any distributions, the greater amount of capital it held in low-return years three and four pulled down its IRR even as its times-capital- returned grew past that of Fund K. Fund J’s ending value is $1,511, and th us its TCR is 1.51. Fund K had ending capital of $629 and distributed $800, for terminal valu e of $1,429 and a TCR of 1.43. But if Fund K’s investors were able to earn more than $82 in years three and four on the $800 they got back (requiring an average annual retu rn of 6.5%), then Fund K did a better job than Fund J. So while we know IRR isn’t perfect, TCR isn’t either, as the fund with the higher TCR may not have been the better performer. Maybe Fund K, with its lower TCR, did the better job. How should we judge fund performance? Only thorough evaluation can lead to the right answer. Complex, multi-dimensional analysis is required. No one number can be relied on to produce a proper conclusion . Here’s a list of things you ha ve to weigh. There simply is no cookie-cutter method – no single calculation – that considers them all.  The internal rate of return,  The times-capital-returned,  The percentage of the capital that was put to work,  The speed at which that capital was put to work,  When investments were harvested and distributions made,  What the LPs were able to do with capital that remained uncalled and/or was returned,  What the LPs could have done with the capit al that was called a nd/or not returned. Finally, it’s important – as in all other area s of investing – to consider how much risk a fund took to earn its return . We’ve become accustomed to evaluating managers of public securities on the basis of risk -adjusted returns, but this approach hasn’t equally reached the alternative markets. Part of th is is because alternative assets generally haven’t been marked to market, and thus there are no meaningful figures for volatility (w ithout those simplistic measurements, risk analysis becomes a real challenge – see “Risk,” January 6, 2006). But clearly, for an oversimplified example, if buyout funds X and Y buy similar kinds of companies and end up with similar IRRs and TCRs, but Fund X uses far less leverage than Fund Y, I would tend to say that Fund X did a superior job. Their IRRs and TCRs alone tell us nothing about their respective riskiness. © Oaktree Capital Management, L.P. All Rights Reserved How are we to ma ke distinctions when the assets purchased aren’t comparable or the differences in leverage and results are less than dramatic? What if one fund buys companies that are more solid than another’s? How do we compare a leveraged buyout fund against an unleveraged venture capital fund (with its very low expected batting average) ? Which is riskier, a highly leveraged portfolio of safe assets or an unleveraged portfolio of risky assets ? It’s hard to make these judgments, but that doesn ’t mean they’re unimportant. And while I’m on the subject of evaluating performa nce records, I want to raise the subject of unevenness in the quality of performance data. Some managers mark their private holdings to market and others carry them at cost. Some mana gers are more optimistic than others in marking to market. Some managers discount large holdi ngs of public securities for illiquidity while others do not. And some managers highlight the results on just their realized investments, which invariably are the best. For these and other reasons, IRR or TCR figures simply can’t be accepted at face value for funds that are still in oper ation and thus haven’t turned all or almost all of their investments into cash. UWhich Return Matters? – Real-Life Example #2 Another look at our real-life e xperience will give a clear view of the absolute conundrum posed by performance assessment. We held a first closing for Opportunities Fund IVb in May 2002, at which time we drew down $51 million. We av eraged down while Enron bonds slid and continued to draw capital and i nvest it as the whole distressed de bt market tanked in June and July, saddling the fund with some very significant mark-to-market losses in percentage terms. The market bottomed in August-October, by th e end of which period we had gotten the fund more than 70% invested. Investor sentiment turned up dramatically in November, giving the fund a 15% gain in that month alone – now with $1 billion invested. Here are the results: Time-weighted Return Dollar Profit May - July -18.6% ($ 33.8) August - December 22.3 229.2 8-month totals -0.5% $195.4 As you can see, the fund had a large percentage loss in the fi rst three months and a large percentage gain in the subsequent five months. As a result, on a time-weighted basis, it showed a small overall loss for the eight months taken together. But the fund was a lot smaller in its initial down months than it was in the later up months. Thus the LPs made a total of $195 million . . . whereas the time-weighted return says they made no money at all. © Oaktree Capital Management, L.P. All Rights Reserved The $195 mi llion dollar profit tran slates into a 30.7% return on the $640 million of capital employed in the fund on average during the eigh t months. And that 30.7% return on average capital employed annualizes to 49.4%. Finally, the annualized IRR for the eight months – the proper measure, according to the experts – was 61.4%. So here are the returns for the fund: Time-weighted return -0.5% On average capital 30.7 On average capital (annualized) 49.4 Internal rate of return 61.4 Was the fund a marginal loser or a booming success? You pay your money and you take your pick, as my mother used to say. But clearly, there’s just one conclusion to be drawn with absolute certainty: no one figure is capable of rend ering a precise picture of fund performance, particularly as re lates to short periods of time. UShort-Term Success Because IRRs are annualized returns, the results for part-year inves tments can be highly misleading. I feel it is alw ays undesirable to annualize retur ns on part-year investments, but doing so is an unavoidable asp ect of calculating their IRRs. For me, it was the onset of option trading that firs t highlighted the folly of annualizing short-term results. Back around 1973, exchange-traded options came into existence (whereas prior to that time, options were an obscure corner of the investment world, traded over the counter among “put-and-call brokers”). This made trading much easier; options attracted a lot of attention; and the “buy/write” strategy becam e the new “silver bullet.” In a buy/write, you buy stock and write a call option that gives someone else the right to buy the stock from you at a fixed “strike price” fo r a specified period of time. Suppose you buy 100 shares of XYZ at $40 and for $6 sell a call optio n that will permit someone else to buy those shares a month later at $35. The total proceeds to you when the option is exercised will be the $6 option premium and the $35 exercise price, for a total of $41. Your investment is $40. The gain of $1 in one month, or 2.5%, annualizes to 30%. So people walked around saying, “I just put on the XYZ buy/write at a 30% return.” But at best they would have $41 in their pockets for every $40 they started with, and that doesn’t sound like a 30% gain to me. (As usual, not only were the merits of a would- be silver bullet overstated, but its dangers were often overlooked. Your dollar of profit and that beautiful 30% a nnualized return were entirely contingent on the stock being above $35 on the option expiration date. If the stock fell, say, from $40 to $30, the option would not be exercise d and you would be left with stock worth $30 and the $6 option premium – for a total of $36 and a loss of $4 from the invested cost of $40. And that 10% loss is real, not annualized!) © Oaktree Capital Management, L.P. All Rights Reserved It’s univer sally agreed that IRR is the right t ool with which to evalua te vehicles like private equity funds. And all appro aches to calculating IRR implic itly annualize the returns on investments held for less than a year and on funds that have been in ex istence for less than a year. There is no altern ative, despite the shor tcomings of annualizing. Of course, an investment shouldn’t be judged to be successful on the ba sis of a high IRR alone, especially if the TCR is low. Note, for example, that a 60% IRR on a $10 investment will produce a gain of $16 over two years, but fifty ce nts if the opportunity lasts just a month. Certainly the two investments cannot be desc ribed as having been equally successful. Now more than at any other time, I hear a lot of clients say their private equity managers are producing ultra-high IRRs over very short periods of time . . . but low times-capital-returned ratios. UDividend Recap Magic Whenever a company borrows money, it becomes more risky, everything else being equal. Let’s say a company has $200 of debt and $200 of shareholders’ equity supporti ng $400 of assets. If the value of its assets declines 50% , its assets will just equal its de bt, and its equity will be gone. Now assume it borrows $100 with which to buy a dditional assets, giving it $300 of debt and $200 of shareholders’ equity suppor ting $500 of assets. It only take s a decline in asset value of 40% to wipe out its equity. This demonstrates that when a company increases its debt, the impact of subsequent developments is magnified. That’s why borrowing is also called leverage . . . and why borrowing makes companies riskier. But what if it borrows money and gives it to th e shareholders? Take the same company with $200 of debt and $200 of equity. Assume again that it borrows $100, but this time, rather than buy assets, it distributes the cash to its equity investors. Now it has $300 of debt and $100 of equity supporting the same $400 of assets, and it takes just a 25% decline in the value of its assets to erase its equity. So whereas all borrowing makes companies riskier, borrowing for dividends greatly amplifies the effect, as the as sumption of debt doesn’t lead to either the acquisition of productive assets Uor U an increase in cash reserves, but merely a decrease in shareholders’ equity. For this reason, lenders should view borrowi ng for dividend distributions with extreme skepticism. But it is a feature of the current capital market environmen t – with its excess of enthusiasm and shortage of caution – that transactions designed to replace equity with debt have become commonplace. According to CSFB, in the 36 months that began April 1, 2003, $68 billion was borrowed through high yield bond issuance or bank loans with the stated purpose of paying dividends or repurchasing st ock, whereas deals of this sort were largely unheard of prior to that date. This is a clear sign of imprude nce on the part of t oday’s capital markets. Of course, as they say in golf, “every putt ma kes somebody happy.” The lender’s lack of caution can work to the borrower’s benefit (assuming he can avoid financial mortality). In the case of dividend recaps, the beneficiar ies are buyout funds and their limited partners. Certainly 10 © Oaktree Capital Management, L.P. All Rights Reserved comp anies have appreciated in value in the last few years, but a substantial portion of the high IRRs being reported by buyout funds is due to fi nancial engineering and the availability of equity-replacement debt. Dividend recaps are permitti ng equity investors to take some or all of their capital off the table, reduc ing their capital at risk and le veraging up their reported rates of returns. But it should be noted that whereas dividend recaps raise IRRs, they don’t necessarily add to investors’ dollar profits. (And if they increase the total leverage on portfolio companies, they can jeopardize the recovery of any remaining investment.) Let’s say a fund buys a company for $200 expecti ng to make $40 in a year, for a 20% IRR. Assume a wacky capital market immediately lets the company borrow and dividend out $180 through a dividend recap. Now the fund’s invested capital is down to $20, and the $40 expected profit represents an IRR of 200% instead of 20%. The reported retu rn is beautiful, but the fund’s expected gain is still just $40. Dividend recaps increase fund investors’ wealth only if the amounts dividended out can be reinvested pr ofitably. Short of that, they represent financial engineering but not value creation. That – among other things – is the reason why I’ve titled this piece “You Can’t Eat IRR.” A high internal rate of return does not in a nd of itself put money in one’s pocket. Only when it’s applied to a material amount of inve sted capital for a significant period of time does IRR produce wealth – something which is often (but no t always) signified by a high TCR. Investors evaluating fund performance should look at both IRR and TCR . . . and beyond. USo, Bottom Line: Good or Bad? – Real-Life Example #3 Just as this memo was about to go to print, a friend showed me the 2005 report of a fund of funds and asked what I thought of its performance. Here are the facts: The fund was formed in mid-2001 to buy secondary partnership inte rests (that is, interests in f unds that limited partners want to get rid of). My friend committed $750,000. Gi ven the carnage earlier this decade in buyout funds and, especially, venture capital funds, he felt (and still feels) his timing was quite good. The fund’s report consists of fina ncial statements only, without any discussion to help a reader understand the implications or limitations of the figures. As concerns performance, the fund reports a since-inception internal rate of return of 27.1% and a “multiple of cost” of 1.45. So far, pretty good. But let’s go behind the numbers.  The first thing worth noting is that only $600,000 of my friend’s $750,000 capital commitment has been drawn down. He doesn’t understand why, given th e dislocation of the early 2000s, all of his money hasn’t been put to work. He suspects the General Partner may have taken too much in the way of capital commitments. (And he feels particularly badly that even before his fund has become fully invested, the GP has formed a successor fund.) 11 © Oaktree Capital Management, L.P. All Rights Reserved  The 27.1% IRR suggests the fund has done a goo d job with the capital it called down, but $150,000 rema ins in my friend’s money market account. Thus he suspects his effective return on the entire $750,000 is lower because of the fund’s slowness in putting his money to work.  He also suspects that the 1.45x “multiple of cost” is misleading. That is, the $600,000 he contributed has been turned into $873,000, for a gain to date of $273,000. But he set aside $750,000 for this fund, and the $873,000 of current value (distributions plus assets still held), when added to the $150,000 not yet drawn (for a total of $1,023,000), represents a multiple of only 1.36 on his capital commitment.  As of the end of 2005, the fund was roughly 4½ y ears old. If it had invested his $750,000 at 27.1% for that entire period, he would have $2,178,000. If it had just earned a 27.1% return on the $600,000 that was actually drawn down, he would have $1,742,000 (plus the undrawn $150,000, for a total of $1,892,000). And yet, he has just $1,023,000.  The IRR of 27.1%, if applied to his c ontributed $600,000 (forget his committed $750,000), would have produced $1,142,000 of gains. A nd yet he sat at the end of 2005 with $273,000 of actual gains. Simplistically to me, th is suggests his contri buted $600,000 has been at work earning 27.1% for only about a quarter, on average, of the 4½ years since the fund’s inception. This illustrates the shortcoming of I RR taken alone: its failure to penalize the GP for failing to put the money to work and keep it at work.  Finally, since the fund has already returned mo re than half of the $873,000 into which the $600,000 grew, it’s extremely unlikely that even further good returns will produce ultimate dollar gains approaching the amount he thinks he should have. The fund reports an IRR of 27.1 % and a TCR of 1.45. But clearly, my friend doesn’t have anything near the profit he would have had if a ll of the money had been invested promptly and kept invested. And the 1.45x “multip le of cost” is irrelevant to him; he wants to know what the GP made for him on his entire commitment, not ju st the part it drew down. Using this fund’s approach to calculating the multiple, the GP l ooks better if it makes a few high-return investments, whereas the investor would be better served if it invested the entire committed amount – even at a materially lower return – and kept it out there longer. My friend has $1.36 for every dollar he committed, but a 4½-year return of even 15% on his entire commitment would have given him $1.86. An IRR of 27.1% sounds impressive. Does it m ean the fund has done a good job? It seems to me that the GP accepted more committed capital than it could invest in a timely manner, charged fees on that higher amount, put its ca pital out very slowly (and not ye t in full), and wasn’t able to keep it out for long. I doubt the fund’s LPs i nvested to earn 36 cents over 4½ years per dollar they committed. So no, I think, not a good job. The real bottom line is that my frie nd committed $750,000 4½ years ago and has $1,023,000 today. That’s an average annual advance of 7.3 %. As Clara Peller used to say in the burger commercials, “Where’s the beef?” 12 © Oaktree Capital Management, L.P. All Rights Reserved In this case – as in many, I suspec t – both the IRR and the “multiple of cost” are next to useless. It takes thought and insight to figure out how a fund did. As in all things, looking at published figures m ust be just the first step. * * * Making a lot of money with the ri sks under control isn’t ea sy. It’s not even easy to identify the best performing managers. Not only is the quantification of returns themselves subject to debate, but it’s often far from obvious whose risk-adj usted-returns are the best. All performance assessment demands quantitative ability tempered by judgment. But there is no alternative. Reliance on a single figure can’t possibly provide the answer – not even IRR. July 12, 2006 13 © Oaktree Capital Management, L.P. All Rights Reserved 14Legal Information and Disclosures This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. Oaktree has no duty or obligation to update the information contained herein. Further, Oaktree makes no representation, and it should not be assumed, that past investment performance is an indication of future results. More over, wherever there is th e potential for profit there is also the possibility of loss. This memorandum is being made av ailable for educational purposes only and should not be used for any other purpose. The information contained herein do es not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain inform ation contained herein concerning economic trends and performance is based on or derived from informatio n provided by independent third-party sources. Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information has been obtained are reliable; however, it cannot g uarantee the accuracy of su ch information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, including the information cont ained herein, may not be copied, reproduced, republished, or posted in whole or in part, in an y form without the prior written consent of Oaktree.