Can IRR be used to estimate equity multiple?
Had an interview question recently that asked me “if a deals projected IRR is 20% over a 5 year hold period, what is the equity multiple roughly?”. I was somewhat stumped by the question. If someone could help clarify, that would be greatly appreciated it.
.2 x 5 = 1 = 100% total return = 2x EM
Thanks for this. How does the math change when the IRR is higher as a result of a 2 year hold due to time value of money? If the IRR was 50% on a 2 year hold, would EM still be 2x?
Yes
OP be aware that this is a gross oversimplification, but for interview purposes they'll accept this math. It doesn't account for compounding or TVM, however, so if you're given numbers where its easy enough to approximate a number with compounding then you should do so.
For example, I've had the inverse question of "if you double your $100 over 4 years, what is your IRR?". The answer is about 20% (a bit over 19%) -> 100*1.2*1.2*1.2*1.2 = 207.
A 20% IRR over 5 years is more like a 2.5x
1.2*^5= 2.49
I was about to say a 15% IRR is a 2x
This is completely wrong^^
I was oversimplifying in the above comments, and incorrect. Here are two scenarios with 20% IRR but much different EM.
Scenario 1
Y0 -$100
Y1 $0
Y2 $0
Y3 $0
Y4 $0
Y5 $250
IRR = 20%
EM = 2.5x
Scenario 2
Y0 -$100
Y1 $119
Y2 $0
Y3 $0
Y4 $0
Y5 $2
IRR = 20%
EM = 1.21x
I mean, the math is right. One fifth of five is one, but that doesn't having any meaningful implications.
There are rules of thumb for that kinda stuff. If I remember correctly, if you double in 5 years, it's a 15% IRR, and if you triple in five years, it's 25% IRR. If you double in three years, it's 26% IRR, and if you triple in three years, it's 44%. So if it's 20% IRR in five years, it's somewhere between 2-3. You can just go with around 2.5
Rule of 72
Can somebody get out the excel for this?
This sort of question is generally to see how you think on the spot with a hard question rather than to see if you’re one of the hardos who remembered MOIC / hold period IRR matrices in technical interview guides. Use the rule of 72 for this, divide 72 by the growth rate to work how rough time period for it reach 2.0x, c. 3.5 years in this case. Multiply 2.0x by 1.1 to approximate for the remaining half year to get 2.2x, and then multiply by 1.2 to approximate for the remaining year to get 2.64x. Correct answer is 2.49x, so you’re close enough with this method. Mention all your steps out loud as you walk through it so the interviewer can see your thought process.
I'm genuinely confused by these responses to what seems to be a simple question.
Year 0 (12/31/2020): -$100
Year 1 (12/31/2021): $20
Year 2 (12/31/2022): $20
Year 3 (12/31/2023): $20
Year 4 (12/31/2024): $20
Year 5 (12/31/2025): $120
This gives me an IRR of 20% (XIRR 19.99%) and EMx of 2.0. What am I missing?
In practice, it's rare to underwrite a deal with a 20% cash-on-cash like outlined here. Typically most of the return is on the exit which means a higher multiple for the same 20% IRR
This is a reasonable and much simpler way of looking at it. Generally when these questions are asked I think the interviewer is working on the assumptions it’s compounding growth rather than a 20% cash on cash distribution. Neither are wrong, hence why it’s important to clarify your assumptions to the interviewer as you walk through your calculation.
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