Importance of Internal Rate of Return (IRR) – An Investment metric

Importance of internal rate of return (IRR)

In this blog, we shall discuss on the importance of Internal Rate of Return and how venture capitalists, analysts and investors rely on IRR to determine the return on investments yield.
IRR is commonly used to evaluate the attractiveness of multiple investments.Projects/Investments with highest IRR are given the highest priority.
As multiple projects have different sources of cashflows generated, comparing IRR is difficult. For instance some investments use debt for funding where as other investments are funded on internal accruals. Some investments are of more strategic importance to a company than others.Hence it is important to disaggregate IRR to understand and seperate investments which generates value due to the firm value from the financial engineering.

Disaggregating the internal rate of return (IRR)

  • IRR is the most important benchmark used to evaluate the performance of Private equity funds.
  • Hence disaggregating the IRR will provide insights to analysts as well as investors when investing in these funds.

Baseline internal rate of return (IRR)

  • This is the return that investors forecast from the target business without implementing any performance improvements in its business operations post acquisition.
  • High cashflows reported from baseline business indicates the attractiveness of the acquisition and how the investor was able to acquire the target at a good rate.

Improvements to business performance

  • The investor post acquisition will take steps to improve the performance of business like improve earnings, reduce costs and increase revenues.
  • The returns from this metric is critical to both PE firms and strategic acquirers as it gives them a clarity during the due diligence on how much improvements can be done on the target firm business operations.

Strategic Repositioning in internal rate of return (IRR)

  • Repositioning an investment would involve the buyer making investments on the target company to transform their business and make them future ready to exploit multiple opportunities.
  • These investments can include doing product launches, entering to a new market, adding new product to the target portfolio, divesting non core business or acquiring new business.

Effect of Leverage in internal rate of return (IRR)

  • Private equity firms use debts to fund their investments and hence it is important to understand how much of the IRR is is driven by leverage.
  • To estimate the unlevered cash flow, the total cashflows at exit is then added with cashflows to be paid for debt and interest payments.The IRR using leverage should be more than the IRR when the investment is funded through equity and internal accruals.

Comparing projects beyond the bottom line

  • Two different investments may generate bottom line for the investors but the source of value would be different.
  • One of the investments may have earned returns due to financial engineering where as in the other investment, the management might have done business improvements and transformation programs like high capital investments or an acquisition which can result in new cashflows.
  • This insights becomes more important in evaluating Private equity funds who depend on financial leverage to generate returns.Funds generating high returns through performance improvements in the target business are robust and perform well in all scenarios.When funds rely on financial leverage, then their performance is high when credit is cheap at low interest rates.

Conclusion

  • Disaggregating internal rate of return (IRR) is important for investors to get insights on the source of value creation of their investments.
  • An investment where the high IRR is generated due to performance improvements of the target business would be indicated by management changes and strategic repositioning.
  • A firm focused on Financial engineering skills will benefit from leverage effects and is dependent on low interest rates.


Leave a Reply

Open chat
Powered by