DCF CoE vs LBO IRR
Hi all,
- Is the target IRR (for equity) used in a LBO model the same as Cost of Equity in a DCF model?
1.A If yes, how can the value output of the two model types differ if projected period, cash flow spend/capital structure, and exit multiple is the same? (lets leave Gordon out for now)
1.B If no, why can you on one hand target a lets say 25% IRR, while on the other hand having 20% cost of equity - hence saying "we only need 20% return"
What am i missing?
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You're welcome.
No - they are not the same. Cost of equity in a DCF model is the rate of return an investor should "expect" to receive to compensate them for the risk of an asset (i.e. the price volatility in relation to the market [Beta in the cost of equity calculation is an adjuster for the "risk" / co-variance of price in relation to the market]). Cost of equity is based on regressions of historical price data of publicly traded securities.
Internal rate of return is a "target" return on invested equity based on debt, entry / exit price and cash flow assumptions in a LBO. An LBO is an "affordability analysis" - meaning it tells you how much you can "afford" to pay for an asset based on the cash flows, capital structure and exit price / multiple. The IRR is based on fund hurdles and perceived risk of the single asset you are running the LBO on. Private equity target IRRs / hurdles can vary significantly based on the limited partner base, industry of focus (if any) and overall investment strategy (i.e. late stage investment, growth capital, turnaround / restructuring, etc.).
Hope this helps.
They are not the same ideas in concept. However, if you have a COE of 25% and IRR of 20%, you wouldn't pursue the LBO with 20% return, because you would rather invest elsewhere than the LBO.
Thank you, that makes a lot of sense!
Just a follow up on this - how would an investor having a "target" return of 20% know the difference between two investments with the same expected entry,exit, leverage and CF (one project having a high systematic risk (beta) and the other having low systematic risk, and ignoring idiosyncratic risk in both projects ). i.e Investment 1 CoE > Investment 2 CoE.
In other words, how does the investor know how "well" he is compensated in terms of risk adjusted return when there are no inputs adjusting for risk in the LBO model?
You set your risk thresholds via the IRR target to achieve a theoretical risk adjusted return scenario. You might also model several different IRR scenarios based on different cash flow cases (i.e. upside generating 30%, base case generating 20% and downside case generating 10%). Then, you can assign probability weights to each scenario, based on an educated guess, to arrive at a risk adjusted expected IRR. Said differently, you underwrite the business in the LBO from a risk perspective by setting appropriate IRR targets.
For example, a cyclical residential new construction or oil & gas play may have a target IRR of 40% because they are higher risk bets. If you are looking at a highly stable recurring revenue model in the food industry, you may underwrite in the 18-22% range, because on a risk adjusted basis the return is still very attractive. There are also other things to consider such as portfolio weighting of certain industries, investment strategy, etc.
Is this a homework question?
Thank you, and no this is not some homework question.
This is me trying to sort out if there is a link/no link between the two, and im sorry for dwelling on the same thing.
As you have different IRR targets for each industry this means target IRR is set based on "fund hurdles and perceived risk of the single asset". Does this mean that the IRR is based on some risk measure (i.e CoE) + a premium?
For example - Your fund has IRR at 40% for two identical E&P projects. Both project will return a IRR of 40%. Then your fund would be indifferent as to what project you would choose.
After a while you find out they are similar in terms of CF, lev etc, but not in terms of risk as the first project is an American Shale Oil Project while the other is a much "safer" EMEA exploration project. Lets say for the sake of it that the CoE of the ASOP is 40% and the EMEA is 20%.
Given both projects can yield a 40% IRR, you would go for EMEA.
If the IRR for ASOP is 60% and the IRR for EMEA is still 40%, both projects yields excess returns of 20%. I would then again be indifferent to what i choose.
I guess my questions boils down to if the IRR is some absolute or constant measure, or a risk measure (fex. CoE) + a premium?
Thank you for your help! Very much appreciated!
Got it. Good question.
For IRR, it really comes down to fund specific nuances within benchmarking and the LP network. For example, some funds may take a benchmark of the 10-year S&P 500 performance or some other arbitrary (e.g. 15%) "hurdle" before carry kicks in for the general partners. On the other hand, some funds don't have a set hurdle rate from the LP(s). In the former, you have a "base level" of risk through a benchmark, then have additional BPS to hurdle to compensate the LP investor for a riskier asset class / less liquid investment. So, there can be an implied cost of equity, but it may or may not be explicitly stated.
In your example, this is where you can see some conflict of interest (depending on fund structure) between the LP and GP bases. If there is a higher hurdle rate before the carry kicks in, GPs are incented to take on more risky (higher target IRR) projects in order to surpass the hurdle and maximize impact of carried interest.
Make sense?
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