🔑 more money for you if you understand these....
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If you're in the world of investing you know the metrics behind success are fuzzy at best...
But all of us here are either investors or plan to be investors.
So let's talk about the metrics that capital allocators plaster on their marketing materials.
This may be a bit dense and wordy if it's your first time reading some of these topics. I encourage you to save this post for later and re-read it a few times...
The downfall of IRR
The PE world revolves around one key metric: Internal Rate of Return (IRR).
IRR is simple but faulty. It measures how much an investment returned relative to the time period.
It was invented with good intentions.
Before IRR, investors simply shared how much money they made as a multiple on their invested capital.
So imagine two different investments that returned 2x, but investment Investment A took 1 year, while Investment B took 10 years to do so.
We would obviously prefer investment A in this situation. But before IRR we didn't have a metric to show this performance on a consolidated basis.
So someone smart invented IRR...
The problem with IRR is that it can be gamed to make returns look better than they are.
(you can read the inspiration post here on X)
While every metric used to measure investment return can be gamed in some way (I'll get to a few other examples below), IRR has been particularly problematic.
There are a few ways to achieve a high IRR:
- Make a great investment and exit in a reasonable time frame
- Make a high-leverage investment, and sell it in a very short time frame.
Here's an over-simplified example that illustrates how IRR can be gamed:
Both investments have a ~26% annualized return, but the long-term hold scenario is returning 10x for the investor - a more desirable outcome than a 10% return.
While this is an exaggerated example with a skewed timeline, the intent is to show one example of how the game is played.
This brings us to what I call “High-octane” Private Equity.
Some PE investors will use high leverage (risky for investors) and seek to sell the business fast to juice IRRs.
This approach is unsustainable.
As an investor, in these situations, your capital has a higher risk and is eaten up by management fees. High leverage and quick acquisition is not a strategy you can repeat without failure.
So is there a better metric?
Some would suggest Multiple on Invested Capital (MOIC).
But the short answer is that every metric has its pros and cons. No one metric will perfectly encapsulate the quality of an investment. They each have a unique purpose. IRR incorporates the time value of money, while MOIC is better suited for measuring total return in dollars relative to your initial investment (without considering the time frame).
Let's look at the first example again. I explained that rate of return is a poor metric for evaluating such a short-term deal like the "quick flip" example I gave.
MOIC will eventually expose the two headwinds you face with short-term investments that have huge rates of return:
- Redeployment of cash. It takes time, sometimes many months or a year to find another good deal and most don’t account for that in their “time value” calculations
- You pay taxes when the returns come back, which hurts your ability to compound long-term returns
What other metrics should you look at, and what are their shortcomings?
Distributed to Paid-In Capital (DPI): The cash returned to investors divided by total capital invested in the fund. Similarly to MOIC, this metric will probably look bad in the short term, but if things go well...the investment vehicle will return capital over time to get a good DPI. This one can be gamed by having a large exit early, or by borrowing to pay a dividend (which sounds foolish, but it happens frequently!)
Terminal Capitalization Rate (TCR): This is basically the expected exit value of an asset based on its cash flows. Like any metric that relies on projections, this one can be gamed by using generous assumptions (a low exit cap rate, for example).
At the end of the day, investors have to account for total return in dollars, rate of return, and time value of money. No one metric will perfectly encapsulate all of those (though IRR comes close - if you only compare investments with the same time frames).
Other ways rates of return can be gamed:
- Relying on a line of credit to fund deals. The capital is technically not deployed during the search phase of a deal, so the timeframe used for the annualized return calculations only starts on the day the deal is closed.
- Only calculating returns on called capital, not committed capital. In other words, if an investor committed $100k but the GP only called $75k, the more useful rate of return from the LP's perspective would be calculated on the $100k, but the GP would calculate it on the $75k. Howard Marks summarized this issue eloquently in a 2006 essay:
- Increasing leverage. Leverage increases returns (in theory), but also increases risks. Without properly accounting for leverage, return percentage doesn't tell you the entire story.
Bottom line: No one metric tells the entire story. Dig deeper into return figures to understand time horizon, leverage, fees, and other aspects tell more of the story.
🔑 Two interesting reads...
Are Dividends good or bad, or neither?
Some businesses are capital consumers, they need it to grow or pay for equipment. Other businesses have decided that they have as much money as they can deploy efficiently and it's better to send it to their shareholders.
But there are risks with agreeing to become a dividend-distributing company...
The Magic of Compounding
In this simple article, the author explains how their net worth is 3.7x the entirety of all the wages they've earned in their lifetime, thanks to compound interest. It's not complicated. But you have to live below your means and invest the rest - which is hard.
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have a great week,
Sieva
Disclaimer: nothing here is investment advice. Please do your own research. The information above is just for information and learning.
