Calling all finance nerds - an academic discussion.
We're all taught in Finance 101 that to value a public company, one discounts the future cash flows by the weighted average cost of capital - specifically, the cost of equity is defined by CAPM - rf + B*(ERP). For a lower beta company, the cost of equity (and WACC on a blended basis), is lower and vice versa. So basically - the cost of capital is fundamentally dependent on the type / quality of business.
Now... in our day-jobs in PE - at least in my experience, everyone basically is targeting an equity IRR of 20-25% gross in buyout regardless of the type of business - software businesses acquired at 20x multiples are targeting the same IRR as industrial businesses that are acquired at 10x. Doesn't this fly in the face of Finance 101 (above).
Which brings me to my question - technically (will never be done in practice), should ICs be adjusting equity IRR underwriting targets dependent on the type / quality of business? E.g. - high-beta industries (tech) need to underwrite to higher IRRs than low-beta ones? Anyone actually see ICs do this? All things equal wouldn't I as an LP prefer a portfolio of health-care (theoretically low beta...) companies underwritten to a 25% IRR than a bunch of tech portcos? (I'm picking on tech a bit but basically substitute "tech" for any industry that has high beta)
Based on the most helpful WSO content, here's what you need to know about targeted IRRs in Private Equity:
General IRR Targets in PE:
Finance 101 vs. PE Practice:
Adjusting IRR Targets Based on Business Type:
LP Preferences:
Practical Considerations:
In summary, while Finance 101 principles suggest that IRR targets should vary based on the business type and associated risk, PE firms typically maintain consistent IRR targets across different industries. This practice may not align perfectly with academic theories but is influenced by practical considerations in the PE industry.
Sources: The Asymmetric Risk Profile: Preparing for the Hedge Fund Interview, The Asymmetric Risk Profile: Preparing for the Hedge Fund Interview, PE interview question - If you can only know 3 things for an investment analysis?, Is Private Equity a Low-IQ Approach to Finance?, https://www.wallstreetoasis.com/forums/anyone-willing-to-share-a-pe-interview-case-study?customgpt=1
While you are correct in saying that different businesses have different Ke, it is incorrect to say that same IRRs are targeted regardless of risk.
Different businesses (sector, growth stage, etc.) will carry a different level of risk and as such target IRR will be different
(1) "Doesn't this fly in the face of Finance 101?"
This assumes finance 101 is correct. Without getting too much into theory, the theory you are discussing is only generally true. It isn't always true. The incompleteness of the theory (descriptively speaking) makes the math a lot harder than you are accounting for in your comment.
(2) IC will have different IRR targets for different businesses, even if it is just a more implicit thing.
I work at a MF, and I guarantee you there is no consistent adjustment in IRR targets per sector for my strategy. It is pure politics that decides which team get blessed with a low MoM to underwrite, and which ones get fucked because they need to underwrite 3.0x returns
Awww. You can seethe at me better than that.
"It is pure politics that decides which team get blessed with a low MoM to underwrite, and which ones get fucked because they need to underwrite 3.0x returns" literally supports what I said. This is literally you providing support for "IC will have different IRR targets for different businesses, even if it is just a more implicit thing." You are giving an explanation for why what I said is true. Politics being why there are different MoM requirements is literally saying that IC will have different targets for different businesses.
It is hard to take you seriously when you posture as if I am wrong when what you say supports what I said.
Politics has nothing to do with the underlying business being evaluated? I am not quite sure how you make the connection? It is literally "this partner is well liked by the IC because he did X Y Z" and "this partner is out of favour because his portco went to shit and his best buddy on ExCo got pushed out so he has a harder time to push deals through". Or "this partner is threatening this guy's spot so he has a higher barrier to clear so he can get cut and not replace one of the big wigs". How is that related to "why yes, of course IC adjusts for each business characteristic". No, they don't, they have dozens of those a week to go through they read the headlines and make some high-level decision based on how well they like the team pushing the deal or if they recently invested in that space/geographic or not. There is little intellectual rigor or honesty.
(1) "Politics has nothing to do with the underlying business being evaluated? I am not quite sure how you make the connection?"
The problem is that you are just a bot regurgitating talking points instead of actually engaging in the conversation. YOU are the only one saying anything about the underlying business. I am talking about the IC and how they determine IRR thresholds. That has literally nothing to do, in and of itself, with the specific underlying business before the IC. A threshold for what is an acceptable return, and the specific return of the opportunity at hand, are not the same thing.
You should know this.
(2) You are yet again providing further support for my point. I literally just said "IC will have different IRR targets for different businesses." What you are saying is literally continuing to support my point.
You are making the argument that "It is literally this partner is well liked by the IC because he did X Y Z." (Internal quotations omitted). That is literally saying that IC has a different return requirement for that company compared to others.
You are making the argument that "this partner is out of favour because his portco went to shit and his best buddy on ExCo got pushed out so he has a harder time to push deals through." That is literally saying that IC has a different return requirement for that partner's companies compared to others.
You are making the argument that "his partner is threatening this guy's spot so he has a higher barrier to clear so he can get cut and not replace one of the big wigs." That is literally saying that IC has a different return requirement for that company compared to others.
You are making the argument that "[IC makes] some high-level decision based on how well they like the team pushing the deal or if they recently invested in that space/geographic or not." That is literally saying that IC has a different return requirement for that company compared to others.
"There is little intellectual rigor or honesty" is entirely accounted for in my claim that "IC will have different IRR targets for different businesses." You notice what my statement doesn't include, right? My claim says nothing about WHY IC will have different target returns. I only said that they will be different for different businesses (and that there is economic theory that supports this, albeit you haven't contended this claim yet).
How is it that you posture as if I am wrong yet you provide so much support for how I am correct? This is quite impressive.
(3) Show me where specifically I said "why yes, of course IC adjusts for each business characteristic?" Provide me the exact quote. Oh wait. You can't. Because I never said anything that this could possibly being referring to. Because what I said was "IC will have different IRR targets for different businesses."
You are lying about what I said. You can do better than this
Nuance that helps to abate this: PE investments typically de-risk the beta of an investment - they prioritize competitive moats, stable cash flows, etc
You are 100% correct and people in the thread are coping. The real answer is this: PE is judged and incentivized on absolute returns, rather than relative. It doesn't fucking matter if you actually create value (e.g. the IRR you underwrite is higher than the cost of equity of the investment being considered), you can perfectly underwrite a business at 20% IRR when cost of equity is 25% (which happens a ton given how leveraged to the tits we are). And everyone will think you did a great deal. And this is why ICs don't adjust between sectors and why their job is pure BS. This is also what makes it the greatest business on Earth. Now for the sad part: you won't see a dime of the money that is pilfered away from LPs this way, all the boomer partners at the top will make sure of it.
There's a few dimensions here.
1) CAPM is only applicable with sufficient diversification, otherwise beta alone doesn't reflect all of the systemic risk you face so you're actually understating your WACC from an academic POV.
2) There's a point of view that the academic definition of risk is wrong entirely whereas in finance 101 risk is defined as volatility, some would argue that the only real risk is permanent loss of capital and everything in-between doesn't matter. Tech is high beta but do you really think a B2B SaaS business is more risky than a commoditized industrials widgets business that exposed to supply chain and oversupply/end market demand risk?
3) I work in growth/software PE and you'd have to build a 10+ year DCF to get to a terminal state and I think at that point I don't know if trying to predict operating metrics more than 5 years out is really that much more accurate than looking at trading comps and haircutting them to be conservative
4) My IC absolutely does look at the execution risk/asset quality and make a determination of the IRR we underwrite to (e.g. company is based abroad and requires heavy operational lift so base case should be 18% instead of 15% etc.) but honestly it's pretty binary for quality assets in my industry, every competitive auction will be won by the person who can underwrite to a 15% base case (given reasonable assumptions) so it's really a matter of determining which risks you think you should get paid for and which are you willing to eat.
1) CAPM needs for the majority of investors (as in most of capital out there, not even just in PE but worlwide across asset classes) at large to be able to diversify at will and thus at the margin for any asset you only get rewarded for systemic risk. Honestly pretty hard to argue that this isn't the case for the most part in practice. There is plenty wrong with CAPM but that hypothesis is not one of them
2) Yes you can argue that mainstream finance is wrong (there will always be people disagreeing about anything), but this is by and large a fringe minority and not a solid argument against the OP (or most finance academic research)
4) This is precisely the issue, for any business and situation there is ONE theoretically correct cost of equity (except proprietary deal angles etc. which do happen but are the exception rather than the rule), and at the margin since this is a competitve market any auction would clear at the price implied by this cost of equity. The very fact that there are people willing to arbitrarily underwrite different and often a lower IRR (and thus destroy value in the process) to win the deal proves the OP right
I'm confused by your comment but OP's point is that funds don't adjust their IRR targets to the assets they invest in and they should. I'm saying people absolutely do, do that in actuality but not based on an academic definition of beta.
Can you elaborate on (1)?
In regards to 2, this is only really demonstrating that you don't know who is saying what and what the finance theory you are discussing actually says.
(1) How many Nobel laureates need to be arguing for a specific alternative theory for it to be more than just a fringe minority? How many econ Nobel laureates need to be arguing for a specific alternative theory for it to be more than just a fringe minority? How many econ Nobel laureates whose contributions to economics is literally the bedrock of modern finance need to be arguing for a specific alternative theory for it to be more than just a fringe minority? How many scientists of the caliber of Einstein and Newton need to be part of developing a specific alternative theory for it to be more than just a fringe minority? How many Harvard Presidents need to be contributing to a specific alternative theory for it to be more than just a fringe minority? How many Treasury secretaries need to be contributing to a specific alternative theory for it to be more than just a fringe minority? How many heads of research at the World Bank need to be contributing to a specific alternative theory for it to be more than just a fringe minority? How many genius grant award winners need to be contributing to a specific alternative theory for it to be more than just a fringe minority? How many national lab directors need to be making contributions in order for it to be more than just a fringe minority? (edit: How many bulge bracket CEOs need to help finance the leading institutions of the field in order for it to be more than just a fringe minority?)
Or when you say fringe minority, are you just relying on an argument ad populum? Are you really just making the argument "other theories that are more descriptively accurate are not as popular as mainstream finance theory. Therefore, those more descriptively accurate theories are not a solid argument against the idea that different companies should have different return thresholds?" Please tell me this is not the argument you are making because it is a fallacious argument. Fallacious arguments are definitionally incorrect. Please tell me you are at least making the argument that there is only one theory that is being contributed to by serious theorists. This is wrong, but at least it is a logically valid argument.
(2) I am going to preface my question with a prediction because I know exactly how this conversation is going to go. I am going to demonstrate how most finance academic research, at least based on the theory Analyst 3+ in CorpFin is discussing, is not descriptively accurate.
The way I am going to do this is to ask Analyst 3+ in CorpFin where in "finance academic research" the anonymous analyst would like to start. They can choose where we begin. And I will just ask them what the assumptions are, how we know them to be descriptively accurate, what percent of the time those assumptions are applicable, and the percent of the time this "finance academic research" actually describes the real world. We will run this train down all the way until it becomes self-evident, even to Analyst 3+ in CorpFin, that what the "finance academic research" says happens will often not actually happen and that this is because it relies upon bad theory (or if I want to be less antagonistic to lazy researchers, incomplete theory).
However, while I will try to do this, Analyst 3+ in CorpFin will run away from this conversation. They did not think they would be talking to someone who actually understands the theory. They thought they could just make stuff up and get away with it because what they are saying feels right and this is a largely professional forum. This is not a forum for academics. So making up what theory says is a relatively low risk endeavor. Most people here don't have a strong enough theory background to call Analyst 3+ in CorpFin out on their nonsense.
So, please. Let me know where in "finance academic research" you'd like to start. What "finance academic research" do you think is actually descriptively accurate? Do you want to start with markets? Do you want to start with company valuations? Do you want to start with rationality? We can begin wherever you want. Dealer's choice.
i think youre forgetting the "private" in this case, which means that certain PE shops specialize in certain industries and so regardless of the business model there is know-how, best practices, network of operators, M&A etc that can guide the business to that 25% IRR target
We may target the same 20% IRR in every memo but are you guys not adjusting the underwrite itself feeding into the 20% to be more / less conservative? If it's a higher quality business in a stable industry, you can have a more bullish underwrite reflecting your conviction in the business.
A sandbag 20% IRR in a cyclical industry is not the same as a shoot-for-the-stars 20% IRR for an A+ business, ultimately linking your purchase price to your operating forecast.
That's not the right way to do it - a "base" case should always represent an [X%] probability of hitting an outcome (and that should be the same across all memos because if its inconsistent, then what the heck does "base" mean?). What you are describing is working backwards and finangling cases to hit some fixed IRR number.
This is how I think about it. The operating forecast "includes" beta, so you don't need to include it when thinking about IRR target (in a mathematical sense, you are essentially canceling out beta in the CAPM formula).
Quis harum reprehenderit aut magnam. Placeat dolor dolores eveniet. Sequi quia vel amet placeat.
Ad ad architecto recusandae amet iure ad et ut. Amet recusandae nostrum eius quidem sunt incidunt. Quia ut est cum expedita autem laboriosam. Voluptatibus exercitationem laudantium hic sint rem enim est et. Et nisi in vitae voluptatibus illum exercitationem.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...