DCF CoE vs LBO IRR

Hi all,

  1. 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?

 

Hi Petesuperstar, check out these links:

  • Unlevered and Levered IRR for Real Estate and Estimating Internal Rate of Return Is there an ideal spread between Unlevered and Levered IRRs ... Thanks in advance guys! What is the Internal Rate of Return? Internal Rate of Return or IRR is ... flows equal to zero. Fo
  • Levered vs. Unlevered Free Cash Flow Difference get paid last in the event of bankruptcy. How to discount levered and unlevered free cash flow? When ... for DCF 's and when are you supposed to use levered FCFs? What is Free Cash Flow? Free cash flow ... the capital structure. When performing a discounted cash
  • Free Cash Flow to Firm vs. Free Cash Flow to Equity Growth Rates which looks at the costs of capital across the capital structure. When performing a discounted cash flow ... someon explain why? What is Free Cash Flow? Free cash flow is a measure of how much money is available to ... growth rate going forward. Definition of Unlevered Free <
  • Levered Free Cash Flow Calculation WSO. Read More About Levered Cash Flow on WSO Levered vs. Unlevered Free Cash Flow Difference ... Here's a Quick Way to Value Unlevered & Levered Cash Flows DCF Analysis: Why do we use an unlevered ... Free Cash Flow to Firm, but discount it with the
  • Difference between LBO and DCF each party; a DCF models cash flows and a required rate of return, based on risk, in order to value ... analysis models cash flows to and from various parties and from that you can calculate a rate of return to ... DCF, you're discounting cash fl
  • Calculating and Estimating Internal Rate of Return following is a brief refresher on IRR. From the Wall Street Oasis Finance Dictionary Internal Rate of Return ... internal rate of return table below. Then you will be able to estimate IRR off of the top of your head! ... IRR for Real Estate Relationship Between Cap Ra
  • EBITDA vs. Operating Cash Flow vs. Free Cash Flow "hotseat" during the technical part of the interview". Distinctions between EBITDA, Operating Cash Flow ... and Free Cash Flow Noticed EBITDA has been a common source of confusion. I hope this helps anyone with ... the Cash Flow Statement. Compare Apple's Net Income to their Cash Flow from
  • DCF Analysis: Why do we use an unlevered Free Cash Flow to Firm, but discount it with the WACC (Levered)? understand why we are using something levered to discount something unlevered! ... So the title is basically my question. We use the WACC to discount the FCF and I do not completely ...
  • More suggestions...

No promises, but maybe one of our professional members will share their wisdom: davidkh keaton.hurt Seth-Lim

You're welcome.

I'm an AI bot trained on the most helpful WSO content across 17+ years.
 
Most Helpful

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.

 

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?

 

Mollitia voluptas ea ducimus quia enim asperiores. Veritatis sint consequuntur repellendus et.

Tempora inventore praesentium et dolores voluptas voluptatem. Voluptates quisquam vel ullam dolorum corporis amet libero. Maxime architecto alias earum nihil ipsum porro sed. Necessitatibus sapiente sed harum eligendi.

Career Advancement Opportunities

March 2024 Investment Banking

  • Jefferies & Company 02 99.4%
  • Goldman Sachs 19 98.8%
  • Harris Williams & Co. (++) 98.3%
  • Lazard Freres 02 97.7%
  • JPMorgan Chase 03 97.1%

Overall Employee Satisfaction

March 2024 Investment Banking

  • Harris Williams & Co. 18 99.4%
  • JPMorgan Chase 10 98.8%
  • Lazard Freres 05 98.3%
  • Morgan Stanley 07 97.7%
  • William Blair 03 97.1%

Professional Growth Opportunities

March 2024 Investment Banking

  • Lazard Freres 01 99.4%
  • Jefferies & Company 02 98.8%
  • Goldman Sachs 17 98.3%
  • Moelis & Company 07 97.7%
  • JPMorgan Chase 05 97.1%

Total Avg Compensation

March 2024 Investment Banking

  • Director/MD (5) $648
  • Vice President (19) $385
  • Associates (86) $261
  • 3rd+ Year Analyst (13) $181
  • Intern/Summer Associate (33) $170
  • 2nd Year Analyst (66) $168
  • 1st Year Analyst (202) $159
  • Intern/Summer Analyst (144) $101
notes
16 IB Interviews Notes

“... there’s no excuse to not take advantage of the resources out there available to you. Best value for your $ are the...”

Leaderboard

1
redever's picture
redever
99.2
2
Secyh62's picture
Secyh62
99.0
3
Betsy Massar's picture
Betsy Massar
99.0
4
BankonBanking's picture
BankonBanking
99.0
5
kanon's picture
kanon
98.9
6
DrApeman's picture
DrApeman
98.9
7
dosk17's picture
dosk17
98.9
8
CompBanker's picture
CompBanker
98.9
9
GameTheory's picture
GameTheory
98.9
10
numi's picture
numi
98.8
success
From 10 rejections to 1 dream investment banking internship

“... I believe it was the single biggest reason why I ended up with an offer...”