How Returns Are Made
Somewhat related to the concepts of Spreadsheet Value and Real World Value, one of our Partners recently asked me what her returns were, which is a totally fair question. And the simple answer to that fair question, and the one I gave, was to look in our most recent audited financials where that Fund reported, and an outside accounting firm had signed off on, a since inception internal rate of return (IRR).
But! What are returns and why do we measure them?
For example, that Fund’s audited since inception IRR is calculated using the amount and timing of Partner capital contributions (which are known values), the amount and timing of capital distributions to Partners (which are known values), and, since its holdings are private and not public, the fair market values of those holdings were they to be liquidated (which are estimated).
A good question to ask is: who estimates those values? And the answer is: we do! Our auditor signs off on them, of course, and I believe they are reasonable, but are those values exactly what those holdings would sell for in the open market right now? Probability would suggest that no they are not.
Yet we do this because everyone agrees that investors deserve to know how they’re doing and also that they’re not invested in a Ponzi scheme. To achieve this shared aim, when accountants are accounting and regulators are regulating, they have a process (called GAAP) by which they try to be precise about ambiguity (and good luck with that, though I appreciate that someone has to try). Because returns, when they are measured prior to an exit and particularly when they rely on estimates of fair value, are a construct akin to any other that attempts to be precise about something that defies precision. In other words, they may be approximate, but they are almost assuredly wrong. And while that may seem obvious in this example of illiquid level 3 (to use GAAP terminology) assets, I would posit that it is also true of liquid assets like public stocks when a dude in an orange headband can tweet some memes and start a frenzy.
Accountants and regulators know this, which is to say that they know that all of the returns being reported are wrong (or at least impermanent). So the defense mechanism is to be wrong low rather than high. That’s because being wrong by being low has become known as being conservative while being wrong by being high has become prosecuted as securities fraud. But whether you’re being conservative or a fraudster, you’re wrong either way.
So the two questions to ask whether you’re measuring or analyzing returns are (1) What? and (2) Why? (which actually are always two good questions to ask about anything).
In terms of what, what returns are being measured, over what time series, and what are the drivers/contributors? More importantly, did the thing generating these returns have agency over any of it. For example, a strategy that saw multiple expansion thanks to a meme may (or may not!) be as sustainable as a capital investment that led to growth.
With regards to why, why are these the returns being measured and presented at all? It could be for accountability, but it could also be to reduce tax liability, increase chances of a future fundraise, buy time, take fees, or because there was no other choice? I’ve seen all of those scenarios, with GAAP auditors signing off on each even though the numbers could have been very different depending on a different why. So I guess what I am saying is that when it comes to how returns are made, despite reading the books, I still have puzzlement and curiosity. But I’m fascinated by the subject even though I don’t have a clear answer about this vital aspect of investing.
Maybe someone should write another book…
– Tim
