Debt IRR?
Wanted to ask a question to the debt community specifically. How do you guys calculate the IRR as a lender? I understand the interest rate obviously plays a part here, but is there anything else added to that calculation? Also, I know some lenders will put a loan on their warehouse line to juice their returns, how is that then calculated as a total IRR? Apologies if this is a dumb question!
The NPV of cash outflows and cash inflows. No different than equity.
You need to think about all of the cash inflows and outflows like any other investment.
You make a loan (an investment and a large negative cash outflow in time zero) and you deduct fee income like origination fees (so your initial contribution is the loan amount). The borrower typically pays for all of the closing costs so there aren’t any additional costs for the lender.
Thereafter, you're collecting annual interest income + extension fees in years 4 and 5 (if your loan manages to stay out that long, many are paid off in 24months) + exit fees (uncommon) + the repayment of your loan (the outstanding principal balance). These are all cash inflows.
Any annual future funding is a cash outflow, which gets netted against income, creating a single "lender net cash flow" line where you can apply Excel's IRR function. It's that simple! And as an FYI, the IRR of a loan is that paper's true cost of debt, so fees are an important part of the equation when looking to compare value across loan options.
Where it gets a little more fun is structuring senior/junior components to manufacture higher returns. The senior component is essentially leverage (just like in a real estate equity deal). Here's an example:
Whole Loan: $100m, 65.00% LTV, S+325
Senior Mortgage: $75m, 48.75% LTV, S+225
You can think of the the whole loan as the equivalent of an unlevered equity deal. The senior mortgage is like a normal lender who advances a 75% LTV loan (3x to 1, debt to equity, or what we call "structural leverage") on your $100m "property". The cost of the senior is cheaper than the unlevered return so you have positive leverage.
The mezzanine loan ($25m) is your levered equity. Take the difference of the whole loan interest and senior loan interest and you have what's left for the mezz, then divide that by your equity, and you get S+625 which would likely yield a low double digit IRR (call it 12% after factoring in fees).
Short hand method, good for mental math, and works for equity cash yields too:
ROE = ROA + (d/e * (ROA - cost of debt))
625 = 325 + (3 * (325 - 225))
Play with that structural leverage and take your senior advance rate to 80% (4 to 1 leverage) or 83.3% (5 to 1) or more, and you'll have a fun time seeing the power of leverage as returns increase exponentially (but so does risk!).
I know from the equity side you would never include fees in your returns because they normally go to the OpCo / a different investor pool. Would suspect it's similar on the debt side
Depends how your business is structured. In a closed ended debt fund, LP investors usually keep the loan fees, so the loan fees are included in the IRR. Like any fund manager, the GP of a debt fund gets paid via a commitment fee on capital raised + carried interest above a preferred return. Thus, the LPs earn interest & loan fees, but pay management fees and promote to the GP. A 12% gross becomes a net 9%ish.
What’s your capital event or terminal value? Is it repayment of principal?
Yes. In a performing loan deal that’s 100% current pay, you simply recoup your principal (plus maybe an exit fee and call protection if applicable). Practically 100% of your profit comes from cash flow (interest).
If you make a 12% IRR at 65 cents on the dollar and don’t need to believe in any appreciation, that’s a damn good risk adjusted investment in my opinion compared to most shitty equity deals in this environment where you need to believe in massive growth/appreciation to achieve marginally better returns. That 16% on paper could be higher, but the risk that it will be lower is also pretty high in a rising interest rate/cap rate environment, whereas safety of principal in debt is not too difficult if you know how to assess credit risk and mitigate it via structure. How would you feel about those equity deals if you could buy them for 35% less? There’s your loan basis…
The fun thing about credit is that the structures are highly customizable. You can also structure deals that are partial current pay and partial or full accrual (payment in kind). For instance, say 8% is paid current and the balance (say 6%) accrues and is due at maturity, so you would earn 14%. In that example, you would be deferring interest so your residual would be your original principal + the profit necessary to earn a 14% lookback IRR (or more with fees) after taking into account the current pay portion. Residual/terminal value isn’t always just the principal.
Lots of good answers here so I am not gonna get deep into the details, but I can tell you a quick way to sense check your excel IRR calcs.
Loan: 100m
Loan term: 5 years
Margin: 5%
Base rate: 5.5% (I am just making the assumption here but obv depends whether it is Euribor/ Sonia / SOFR)
Upfront fee: 1%
Exit fee: 1%
Your IRR for this loan is margin + base rate + upfront fee divided by 5 (you are amortising it by loan term) + exit fee so 5% + 5.5% + 0.2% + 1% = 11.7%
If it was a development loan, you would need to add in commitment fee. In that case this quick calc may not be very accurate as IRR is sensitive to the timeframe of loan drawings, but I think it is still a good way to sense check your excel calcs.
Hope this helps!
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