Private Equity Faces Reality Check as Cash Returns Lag, According to Leemccabe

In a recent LinkedIn post, Leemccabe offers a stark assessment of the private equity industry, suggesting it is on the cusp of confronting a fundamental challenge: the unvarnished reality of Distributed to Paid-In Capital (DPI) after years of reliance on less tangible metrics. Leemccabe argues that the industry’s long-favored metric, Internal Rate of Return (IRR), may soon prove insufficient as a measure of true performance.

The Limitations of IRR in a Shifting Market

Leemccabe highlights the elegance and mathematical appeal of IRR, but points out its potential to obscure the lack of actual cash returned to investors. The post emphasizes that while IRR can paint a rosy picture of performance, it doesn’t reflect liquidity for Limited Partners (LPs). Leemccabe states:

IRR has had a lovely run.
Very elegant.
Very mathematical.
Very useful if you enjoy explaining to LPs why their money is “performing” despite the small administrative detail that none of it has actually come back.

The author contrasts this with the straightforward nature of cash, noting its undeniable presence or absence. According to Leemccabe, recent performance data indicates a significant shortfall in cash distributions compared to historical benchmarks.

Data Underscores Cash Return Shortfalls

Citing data from reputable sources like Bain, MSCI, Cambridge Associates, and Preqin, Leemccabe points out that funds from 2018 through 2021 are substantially behind where they should be in terms of cash returned at comparable stages in their lifecycle. This lag is critical, as Leemccabe explains, because LPs rely on actual cash for their own operational needs.

LPs don’t recycle IRR into the next fund.
They don’t pay pensions with unrealized marks.
They don’t fund commitments with “adjusted” portfolio company optimism.

This fundamental reliance on tangible returns underscores the problem with metrics that do not directly translate to cash in hand. Leemccabe argues that the traditional levers driving PE returns are becoming less effective.

The Erosion of Traditional PE Levers

Historically, private equity success has often been attributed to a combination of factors: readily available cheap debt, the ability to expand multiples through financial engineering or market timing, and a cooperative exit market. Leemccabe suggests that all three of these pillars are now faltering.

A Return to Operational Fundamentals

With these traditional drivers weakening, Leemccabe posits that the private equity industry must pivot towards a more challenging, yet ultimately more sustainable, approach: genuine operational improvement. The author criticizes the superficiality of some value creation plans, which often involve numerous initiatives and extensive reporting without delivering substantive results. Leemccabe advocates for a return to the “boring stuff” that actually generates profit.

Actually improve pricing, sales productivity, gross margin, working capital, retention, conversion, procurement, throughput and cash flow.
Boring stuff.
The stuff that makes money.

The forthcoming years, Leemccabe predicts, will serve as a significant clarifying period for the industry. Some firms will succeed by genuinely building better companies, while others may continue to rely on opaque reporting and inflated metrics. Leemccabe concludes with a pithy observation on the potential disconnect between reported IRR and actual cash returns, suggesting:

“The IRR is fine. The cash isn’t.”

This sentiment, Leemccabe implies, could become a defining, albeit uncomfortable, mantra for the industry in the near future.