Negative IRR
Let's say you have 2 scenarios:
SCENARIO 1
Year 0 (initial investment): 150
Year 1 (end of investment): 140
Money Multiple: 0.93x
IRR: (7%)
SCENARIO 2
Year 0 (initial investment): 150
Year 1 (investment year): 0
Year 2 (end of investment): 140
Money Multiple: 0.93x
IRR: (3%)
Conceptually, I understand what's going here (longer time period and same sub 1.0x money multiple - so less "negative" IRR per year). However, in terms of presentation, this really doesn't make sense as your real return (present value of money) is better in Scenario 1 than Scenario 2.
Obviously not a good investment in any case, but would you show an analysis with these figures, as its a bit counterintuitive?
What?! In scenario 1 you have lost the same amount of money twice as fast as in scenario 2. If you have trouble seeing that, then I think your "intuition" needs some recalibrating...
It's called "internal rate of return" for a reason...
Edit: Finally, I'm not sure you understand how an IRR is calculated given you're talking about different present values...
Mrb87 is being a bit of a dick, this is a legitimate question to me. And your comment about present value doesn't make sense. Two different investment opportunities can be compared looking at the present value of cash flows, or IRR, and this case is no different. Clearly if you take the present value of these two series of cash flows at a 10% rate or something, you get a higher PV in scenario 1.
The answer to OP is that you are looking at IRR over two different time periods, which makes direct comparison difficult. In scenario 1, you lose ~7% per year for one year. In scenario 2, you lose ~3% per year for two years.
But the takeaway is that IRR is a tricky little number to utilize in comparing different opportunities, where timeframe, risk, etc may be very different.
I was referring to the fact that IRR by definition is the rate at which the NPV of your cash flows = 0 (and hence 140=150 in both scenarios) but you're right that's not really the point here. In any case, I still don't understand what's so "tricky" here: IRR is a measurement of rate and it's clear one investment here changes value at a different rate than another. OP is clearly just confused by the negative IRR; it's just a mirror image of a positive IRR.
This is conceptually no different than high school algebra: y=150-10x is clearly declining at a faster rate than y=150-5x.
I'm in a pissy mood because I haven't slept and for no good reason.
Yeah I get what you mean, mathematically it's very simple and not tricky at all to get to the number. But I do think it is tricky to utilize the number effectively, because it's a very opaque way of looking at an opportunity and yet the impulse is just to immediately think higher IRR is better.
You know what they say....you can't eat IRR.
But if you work at a shop that pays bonus out of non-cash P&L generated by equity accounting or revenue recognition of PIK interest, you can get bonus paid out of it.
there are no periodic cash flows, so you would not even consider using a pv calc to make sense of value lost or gained in this transaction. You use pv in dcf scenarios because there are ongoing cash flows in each period and you want to determine what the sum of each period is worth to you today. When I say dcf scenarios, I really mean for strategics. They plan on holding on to the company long-term and want to integrate it into themselves, making the target's periodic cash flows a highly important metric for long-term growth and sustainability.
In an LBO scenario, yes you care about cash flows, but more or less because they are used to pay down debt. Not so much to determine how much a company is worth to you on day 0. What you do care about is the entry and exit price, and IRR gives you the annualized returns of this investment.
Kind of like when you try to figure out actual gains/losses on a stock you bought for your personal portfolio. You don't care so much about the interim, as long as the company is not going insolvent. You do care, however, about the entry price and exit price, and the return (cash on cash instead of IRR, but similar in terms of how you think about what calc to use to determine overall value of an investment).
All this being said, what are these numbers you provide? Cash flows or entry/exit prices? Former, you think in terms of pv, latter you think in terms of irr. I think you need to brush up on your fundamental understanding of these measurements, as they aren't very similar in how they work/when you use them. Hopefully the above helped to some extent.
http://www.oaktreecapital.com/MemoTree/You%20Can%27t%20Eat%20IRR%2007_1…
Wow did not think this was going to be so controversial...you are making something very simple into something very complicated...just punch in these numbers in an Excel and use the IRR formula nothing more, nothing less - everything is quoted in value you receive at that point in time (i.e. invest $150 today, receive $140 2 years from now in Scenario 2)
If someone said would you take an investment with a 20% IRR or 25% IRR, the most obvious answer choice is 25%....Using that same logic doesn't necessarily work here, a lot of people would take Scenario 2 given the higher IRR, but I disagree...
Would you rather invest $150 today and receive $140 in one year or invest $150 today and receive $140 in two years? - Ceteris paribus - Or another way to put it would you rather achieve the same money multiple in 1 year's time or 2 year's time? My intuition says Scenario 1, although the IRR is worse than Scenario 2.
Thanks for the Howard Marks letter, good read...
The main point of my question is how would you present Scenario 1 being a better investment than Scenario 2. I was preparing some slides on a potential investment and the negative IRRs are a bit counterintuitive sometime... that's honestly the point of my question...
I answered your question; the answer is that you can't as a rule interpret IRR meaningfully by just looking at the number. In this case, you have the choice between a -7% IRR over 1 year or a -3% IRR over 2 years; you get a negative 7% return for one year, or a negative 3% return compounded for two years. The "over 1 year" and "over 2 years" description is necessary in order to interpret the -3% and -7% numbers. In such a case, you would prefer the first scenario, you'd prefer to lose the 7% in one year than lose 3% per year for two years.
In this case it's very important to look at the timeframe of the two calculations, and it's important in more normal cases, too. For example, a 25% IRR over 5 years may be a better opportunity than a 40% IRR over 2 years, even if they had the same risk levels, depending on what return you think you can earn on your capital in other opportunities.
Exactly. "You can't eat IRR" is very helpful when you think about the extreme -- would you rather have a 100% IRR in 1 month, or a 20% IRR over 5 years? Unless you can keep finding (very) attractive opportunities to reinvest, I think most people would rather take 20% over 5 years, which is a ~2.5x return on capital, vs. 100% in 1 month, or only a ~1.1x return on capital.
Cool makes sense
Agree. As you guys probably know investing in the distress debt of liquidations often very much deals with when distributions are actually made (i.e. could be in 3 months, could be in 2 years due to litigation or a slow wind down process). If you guess right (i.e. a few months) the IRRs can obviously be off the charts, but if you are wrong your money could be locked up in a liquidation for longer than you wanted. At the end of the day risk is not fully captured by IRR / MOIC and obviously you need to peel the onion a bit deeper. However, when most people talk about investment they focus on IRR, at the cost of talking about how risky that IRR is vs. other investment opps.
Also to mrb87's question...I would ideally do the 100% IRR in 1 month and then invest after 1 month in the 20% over 5 years, an opportunity that should still exist I imagine ;-) In real life, these are the sort of decision portfolio managers need to make in order to get the market beating performances. Event driven liquidations is very much an investment subset that can be very short term, but returns justify the risk if you are comfortable with your thesis. There is a gap between academic analysis of IRR / MOIC vs. real life investment decisions and how people use these metrics and there actual value.
Also to mrb87's question...I would ideally do the 100% IRR in 1 month and then invest after 1 month in the 20% over 5 years, an opportunity that should still exist I imagine ;-) In real life, these are the sort of decision portfolio managers need to make in order to get the market beating performances. Event driven liquidations is very much an investment subset that can be very short term, but returns justify the risk if you are comfortable with your thesis. There is a gap between academic analysis of IRR / MOIC vs. real life investment decisions and how people use these metrics and there actual value.
Negative IRR at year 1 in LBO scenario (Originally Posted: 03/19/2016)
i'm making a model to train and noticed that if i exit at year 1, my equity ends up being worth lower than my initial contribution. i find this somewhat weird can someone shed some light ? the way i explained it in my head was that making the balance sheet bigger did not make market enterprise value bigger the additional leverage lowered my market equity value & made my debt higher.
3 thoughts, either your EBITDA is shrinking in year 1, you're drawing more from your revolver than you're paying down in other debt, or you're assuming that you'd exit at a lower multiple than you entered.
Realistically, you'd only exit in Year 1 if you experience significant cash flow growth or multiple expansion. If you assume neither of those then you come across the situation you're seeing now.
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