"IRR" for a total loss investment... 0% or -100%?
Hi All,
Am having a semi interesting debate with a consultant pitching us a PE firm (we are a fund to funds).
To make a long story short... there are 2 investments in the fund that are TOTAL losses ( 0 recovery).... yes I know terrible!
However, the consultant is trying to convince me that the irr on those investments should be 0%. However, I am leaning towards -100%. 0% to me would be closer to break even, while -100% is truthfully what this was... but that is just logic?
I am new to the industry and this consultant is pretty seasoned. So. I dont look like a total idiot disagreeing with him... what do you all think?
Obviously 0 vs. -100% results in pretty different average performance and would affect manager quartile rankings.
All the examples I found online dont reference total losses.... so I am hoping to harness the power of crowds by chatting with you all.
Many thanks in advance.
O
Just throw the numbers into Excel. It's clear that a loss doesn't provide a 0% IRR but rather a negative IRR.
Thanks for the response. The issue is that since the signs never change its erroring so I can't use that as a test. The below is a quickie example with dates and numbers changed of course.
-1000 1/1/2012 -50 1/1/2013 -5 1/1/2014 -15 1/1/2015
#NUM!Depends on the holding period, right? Would second the comment to put it into Excel. -100% IRR would only be true if the investment was held for exactly one period, I think.
Formula is pretty straight forward...It is: (Exit equity value/entry equity value)^(1/years) - 1
Thus if total loss, exit equity value is zero and you have (0/x)^x -1. This will be -1 (-100%) every time no matter the timeframe or any other variable.
Hope that helps
Exactly! that is what I was thinking .. you cant throw it in excel since the cashflows never turn positive and it just errors. I told the consultant about the -100% by the way and he starched his head and ended up agreeing! Whew... nice to know Im not that big of a dumbass. Thank you for your response.
Right, but you can't use the excel function. The excel function for IRR doesn't handle negative returns
Out of curiosity....let's say a CRE property is sold after 3 years for $60M and you're told the IRR was ~5%.
[ ($60M / Entry equity value) ^(1/3) ] -1 = 5%
So entry equity value is the initial investment?
An IRR of 0% would result in having no growth or loss in value. Going from an investment to a total loss is -100%. The consultant is an idiot.
Thank you! Yeah the consultant recanted! Oh yeah!
I haven't touched valuation in years, but is there any element of discounting / adjusting for eg base interest rates?
Ie investment held for 5 years exits at entry value, no cash flow, surely if the alternative was to hold in government bonds at eg 1% then you use that to adjust IRR to be negative?
edit - I believe I might be talking about discount rate, so eg assuming 3%, then 100m entry, 100m nominal exit, discounted would be net negative so negative IRR
I believe the source of your confusion is that IRR is an un-adjusted (nominal) rate of return. Thus the project and the bond would be seen as 2 separate investments, one with an IRR of 0% and the other an IRR of 1% rather than being rolled into one investment. Because of this a “good” IRR is one that clears a pre-defined hurdle rate which is usually stronger than an IRR simply being non-negative.
Philosophically and mathematically speaking, having no cash in at any point of the investment means there is no IRR. "n.a." would be the most correct answer.
However, from a practical standpoint, -100% would be the "correct" answer, even if mathematically meaningless. As a proof, if you plug into the IRR formula a positive $.01 inflow at exit you will get a (99.9999...%) IRR.
Fire the consultant because 0% is wrong regardless.
This is correct. Technically the IRR is undefined.
Agree on the undefined! I just need a value or some sort for each of the portfolio company performances in order to look at fund level performance properly. Your input is appreciated!
Wish you'd tell us what the name of the consulting company. I would never want to hire a company with staff this retarded doing pitches for them.
I agree with you. It should not be 0%, which is misleading.
Given it doesn't sound like you have a very good consultant - I'm curious how he said this impacts quartile rankings? Quartile rankings should be done at a fund level based off dollar values (so this would be an outflow with no corresponding inflow) - so the IRR of individual investments shouldn't have an impact?
The IRR is ill defined because it relies on a 0/0. But if we were to ascribe a value, it would be -100%.
The scenario is: Pay $1 at time 0; earn $0 at time 1 at an X% discount rate.
set PV paid equal to PV earned:
1 = 0 / (1+X)
Solve for x
1+X = 0
X = -1
Note that X=-1 makes the original equation as 1=0/0, which tells you this is all nonsense.
Fire your consultant.
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