Adjusted cash total return

What Is Adjusted Cash Total Return?

Adjusted Cash Total Return is a specialized performance measurement metric primarily used in the realm of alternative investments, particularly within private equity funds. It represents a refined approach to calculating an investment's return by modifying the underlying cash flow data to account for the impact of certain financing structures, most notably subscription lines of credit. This adjustment aims to provide a clearer and more accurate picture of the capital generated directly from the investment activities, uninfluenced by short-term fund-level leverage. By focusing on the true distributions and capital deployed from limited partners, Adjusted Cash Total Return helps investors assess the inherent profitability and efficiency of a fund's portfolio, offering a more transparent view of its performance measurement.

History and Origin

The concept of Adjusted Cash Total Return emerged in response to evolving practices within the private equity industry, particularly the widespread adoption of subscription lines of credit by general partners (GPs). These credit facilities allow funds to draw down capital to make investments or cover expenses before issuing a formal capital call to their limited partners. While beneficial for fund management, enabling quicker deployment and potentially reducing the "J-curve" effect, this practice can significantly impact traditional performance metrics like the Internal Rate of Return (IRR).

As noted by the CFA Institute, investors, particularly on the institutional side, increasingly began requesting "adjusted returns" that treat cash drawn from a credit facility as if it originated from a capital call.⁸ This shift in reporting gained traction as investors sought to understand the true underlying performance of their illiquid assets without the timing benefits that subscription lines could impart on IRR calculations. The focus became ensuring that the reported Adjusted Cash Total Return genuinely reflected the timing and magnitude of capital contributions and distributions between the fund and its investors, rather than being influenced by temporary financing arrangements.

Key Takeaways

• Adjusted Cash Total Return provides a more transparent view of private equity fund performance by neutralizing the impact of subscription lines of credit.
• It typically involves restating cash flows, treating drawdowns from credit lines as if they were direct capital calls from investors.
• This metric allows for a more "apples-to-apples" comparison of fund managers, regardless of their credit line usage.
• It is crucial for institutional investors and those engaged in due diligence on private market investments.
• While not a standalone metric, Adjusted Cash Total Return enhances the insights provided by traditional financial metrics.

Formula and Calculation

Adjusted Cash Total Return is not a single, universally defined formula, but rather a methodological adjustment applied to standard performance metrics like the Internal Rate of Return (IRR) or Total Value to Paid-in Capital (TVPI). The core principle involves restating the fund's historical cash flow stream.

The adjustment typically works as follows:

1. Identify Credit Line Usage: Determine all instances where a fund drew capital from a subscription line of credit to finance an investment or operational expense.
2. Reclassify Drawdowns: For the purpose of calculating the Adjusted Cash Total Return, these drawdowns are reclassified. Instead of being treated as temporary debt, they are recorded as if they were direct capital contributions (or capital calls) from the limited partners at the time the credit line was drawn.
3. Adjust Repayments: Correspondingly, when the credit line is repaid (typically with subsequent capital calls or distributions), these repayments are removed from the cash flow stream, as the original "contribution" was already accounted for.
4. Recalculate Performance Metric: With the adjusted cash flow series, a chosen performance metric, such as IRR or TVPI, is then recalculated.

For instance, if calculating an adjusted IRR, the calculation would be based on the modified cash flows (original capital calls + credit line drawdowns treated as capital calls, and distributions) to find the discount rate (\text{r}) that makes the Net Present Value (NPV) of all cash flows equal to zero:

Where:

• (CF_t) = Adjusted cash flow at time (t) (which includes original capital calls and reclassified credit line drawdowns as outflows, and distributions as inflows).
• (r) = Adjusted Internal Rate of Return.
• (n) = Total number of periods.

This process essentially simulates what the fund's performance would have looked like if it had relied solely on immediate capital calls from its limited partners rather than utilizing a credit facility.

Interpreting the Adjusted Cash Total Return

Interpreting the Adjusted Cash Total Return provides critical insights into the genuine performance measurement of an investment, particularly within private equity. A fund's reported return, when adjusted for the impact of subscription lines of credit, offers a truer reflection of the manager's ability to generate value from the underlying portfolio companies, independent of short-term financing strategies.

When an Adjusted Cash Total Return is calculated alongside a traditional return (e.g., a standard IRR that includes the benefits of credit lines), the difference between the two metrics can be highly informative. A significant positive difference, where the unadjusted return is notably higher, suggests that the fund's reported performance has been materially enhanced by the timing benefits provided by the credit facility. Conversely, a smaller difference indicates that the fund's performance is less reliant on this specific financing mechanism.

For investors, evaluating this metric helps in making fair comparisons between different funds and managers. It allows them to discern whether a high reported Internal Rate of Return is primarily due to strong investment selection and operational improvements, or partially a function of efficient cash management via leverage. A robust Adjusted Cash Total Return signifies that the fund's inherent investment strategy is driving returns, providing a more reliable basis for future capital allocation decisions.

Hypothetical Example

Consider a hypothetical private equity fund, "Growth Capital Fund I," that closed in January 2020 with $100 million in committed capital.

Scenario A: Standard IRR (with credit line usage)

• Jan 2020: Fund inception.
• March 2020: Fund draws $10 million from a subscription line of credit to acquire Company X.
• June 2020: Fund makes a capital call of $10 million from Limited Partners (LPs). This $10 million is used to repay the subscription line.
• Dec 2021: Fund sells Company X for $15 million and distributes $15 million to LPs.
• Dec 2022: The remaining Net Asset Value (NAV) of the fund is $90 million (from other investments).

In a standard IRR calculation, the March 2020 credit line draw might not be explicitly reflected as a capital outflow from LPs. The capital call in June 2020 would appear as the LP's first contribution. This can shorten the "invested period" for the $10 million, artificially inflating the IRR.

Scenario B: Adjusted Cash Total Return (treating credit line as capital call)

To calculate the Adjusted Cash Total Return, the cash flows are restated:

• Jan 2020: Fund inception.
• March 2020: The $10 million drawn from the subscription line is treated as if it were a capital call from LPs. This becomes an initial $10 million outflow from LPs for the purpose of the adjusted calculation.
• June 2020: The capital call of $10 million that was used to repay the line is effectively nullified in the adjusted cash flow stream, as the "contribution" was already accounted for in March.
• Dec 2021: Fund distributes $15 million to LPs (inflow).
• Dec 2022: Fund's NAV of $90 million is considered (inflow at the end of the period for calculation purposes).

By treating the March 2020 draw from the credit line as an immediate capital outflow from LPs, the Adjusted Cash Total Return calculation will reflect a longer duration for the capital at work, resulting in a generally lower, but more accurate, Internal Rate of Return that represents the true economic performance without the timing benefit of the credit facility. This provides a clearer understanding of the actual capital deployed and returned.

Practical Applications

Adjusted Cash Total Return is a vital metric for various stakeholders within the financial ecosystem, especially in the context of private equity and other alternative investments. Its primary applications include:

• Limited Partner Due Diligence: Institutional investors, such as pension funds, endowments, and family offices, extensively use this metric during their due diligence process when evaluating potential private equity fund commitments. It helps them discern the true economic return of a fund, independent of financing tactics like subscription lines of credit.
• Manager Selection and Benchmarking: By normalizing the impact of credit facilities, Adjusted Cash Total Return enables a more "apples-to-apples" comparison of fund managers. This allows investors to benchmark managers more accurately against peers, irrespective of how aggressively they utilize fund-level leverage. Performance comparison in private markets is challenging due to factors like illiquidity and valuation subjectivity, making adjusted metrics particularly valuable.⁷,⁶
• Investment Committee Reporting: For internal reporting to investment committees and boards, presenting both unadjusted and Adjusted Cash Total Return figures provides a comprehensive view of fund performance, allowing for informed discussions about capital deployment strategies and risks.
• Transparency and Fiduciary Duty: General partners who provide Adjusted Cash Total Return alongside other financial metrics demonstrate a commitment to greater transparency, fulfilling their fiduciary duty to provide a clear picture of performance to their limited partners.
• Risk Management: Understanding the Adjusted Cash Total Return aids in assessing the genuine risk-adjusted return of an investment by stripping away any potential inflation of returns due to the timing advantages of credit lines.

This metric helps investors navigate the complexities of private investment performance, which often faces challenges like late pricing and subjective valuation for illiquid assets.⁵

Limitations and Criticisms

Despite its benefits for enhanced transparency, Adjusted Cash Total Return is not without its limitations and criticisms. One primary challenge lies in the lack of a standardized calculation methodology across the industry. While the core idea is to neutralize subscription lines, different general partners (GPs) or reporting platforms might apply slightly varied approaches to adjusting the cash flow streams. This can lead to inconsistencies when comparing "adjusted" figures from various sources.

Another criticism is the added complexity it introduces to an already intricate field of private equity performance measurement. Private equity returns are inherently difficult to measure accurately due to factors such as long investment horizons, the illiquidity of underlying assets, and subjective valuations of unrealized investments.⁴,³ Introducing an adjusted metric requires more detailed data and can make understanding and verifying the reported returns more challenging for less sophisticated investors.

Furthermore, some argue that entirely stripping out the impact of subscription lines may overlook their legitimate financial benefits. Credit lines can reduce negative carry, enhance liquidity management for the fund, and potentially optimize the timing of capital calls, which benefits limited partners by allowing their capital to remain invested in public markets for longer.² Critics suggest that while transparency is important, completely ignoring these operational efficiencies might not present a full picture of the fund manager's overall skill. As evaluating private equity performance is complex and requires understanding various metrics and their limitations, no single metric provides a complete view.¹

Adjusted Cash Total Return vs. Internal Rate of Return

Adjusted Cash Total Return and Internal Rate of Return (IRR) are both critical financial metrics used in private equity, but they offer different perspectives on an investment's performance. The key distinction lies in how they account for the timing and source of cash flows, particularly concerning the use of subscription lines of credit.

Internal Rate of Return (IRR) is a money-weighted return metric that calculates the discount rate at which the Net Present Value of all cash inflows and outflows from an investment equals zero. It is widely favored in private markets because it inherently considers the time value of money and the irregular nature of private equity cash flows, such as capital calls and distributions. However, a common criticism of IRR, especially in funds utilizing subscription lines of credit, is its susceptibility to "timing games." When a fund draws on a credit line to make an investment and then repays that line with a subsequent capital call from limited partners, the effective holding period for the LPs' capital appears shorter. This can artificially inflate the IRR because the capital is considered "paid in" for a shorter duration.

Adjusted Cash Total Return, on the other hand, seeks to mitigate this timing distortion. It is essentially an IRR calculation where the initial drawdowns from a subscription line of credit are treated as if they were direct capital calls from limited partners at the moment the credit line was utilized. This methodological adjustment removes the timing benefit that the credit line might impart, providing an IRR that more accurately reflects the performance of the fund's investments based on the underlying capital invested by the limited partners. The purpose of the Adjusted Cash Total Return is to provide a "cleaner" view of the fund's investment acumen, independent of its short-term financing strategies, enabling a more direct and comparable assessment of true investment performance across managers.

FAQs

Why is Adjusted Cash Total Return important in private equity?

Adjusted Cash Total Return is important because it provides a more accurate and transparent measure of a private equity fund's performance, especially when the fund uses subscription lines of credit. These credit lines can artificially inflate the traditional Internal Rate of Return by reducing the perceived time capital is "at work." The adjusted metric helps investors see the true returns generated from their committed capital, independent of these financing structures.

How does using a subscription line of credit affect traditional IRR?

Using a subscription line of credit allows a private equity fund to make investments or cover expenses before issuing a formal capital call to its limited partners. When the capital call is eventually made, it repays the credit line. This effectively shortens the "invested period" for the limited partners' capital, which can lead to a higher, potentially misleading, traditional Internal Rate of Return due to the timing advantage.

Is there a universally accepted formula for Adjusted Cash Total Return?

No, there isn't a single, universally standardized formula. While the underlying principle involves treating subscription line drawdowns as if they were direct capital calls from limited partners, the precise implementation and reporting can vary among general partners and data providers. This variability is one of its limitations, making consistent comparisons across all sources challenging without understanding the specific adjustments made.

Who benefits most from understanding Adjusted Cash Total Return?

Institutional investors, such as pension funds, endowments, and sovereign wealth funds, are the primary beneficiaries of understanding Adjusted Cash Total Return. These large investors commit substantial capital to private equity and require highly granular and accurate performance measurement to make informed allocation decisions and fulfill their fiduciary duties. It helps them conduct more robust due diligence and compare fund managers more fairly.

How does Adjusted Cash Total Return improve transparency?

By effectively reclassifying the timing of capital deployment, Adjusted Cash Total Return reveals what the fund's performance would have been had it solely relied on drawing down committed capital directly from limited partners. This enhanced transparency helps investors distinguish between returns driven by astute investment selection and those potentially boosted by the strategic use of fund-level leverage.