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April 30, 2024
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cost of equity
Each fund will have a specific hurdle or target for IRR. Generally for PE, it tends to be a 20-30% IRR target (for a rough range), depending on where the firm is competing. Using that IRR target, you can determine the valuation range in the LBO.
So the fund will pay an initial price that leads to an IRR above the whole fund's hurdle rate (holding all else equal) regardless of the risk of the underlying assets in the deal? Why isn't it risk-adjusted? What am I missing...
To the extent that firm-spefic cost of equity is used, is it estimated with the CAPM? Is it levered up based on the post-deal leverage?
Thanks all
Forget CAPM and cost of equity. Have you built an LBO before? If not, do that and you will learn.
Actually finished building an LBO earlier today. I would suggest the IRR function or the Rate function in Excel, but also make sure you understand the logic behind it.
It's not a question of how to calculate IRR. I'm wondering how a decision maker in the PE fund determines what an appropriate IRR is in order for a specific transaction to be appealing. Thanks
That's a really strange question -- like asking how one determines if a chick is hot enough to fuck.
How the IRR is determined encompasses a range of factors, including the judgement of the decision maker. 20-25% is the general consensus.
The IRR implicitly includes the risk. Requiring a higher IRR means you are assuming higher risk.
He's asking about hurdle rates for individual deals, not how to calculate an IRR. The answer is that it's complex and usually pretty subjective. There are objective ways to get at it (e.g. Govt bond spreads vs T-bills if doing an emerging market deal), but it also can also be influenced by things like leverage and general riskiness of the deal thesis (you'd want a higher IRR on a turnaround than on a low-price deal where you're just relying on debt pay down to drive returns), and even equity check size (you want a higher IRR if it's a relatively small check size to justify the time/investment). All that said, yeah, it tends to be ~22-25% for a typical US deal.
And it should go without saying, but obviously where this comes into play is in the price you're authorized to bid...
Thanks, enjoyed learning about this.
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