Private equity course – IRR

The impact of leverage on return: why banks are always under pressure to lend just a little bit more

Training course provider: Now all I wanted to… to demonstrate there – look at this; if we were just able to get a little bit more debt moving from eighty percent debt to ninety percent – I know these figures are unrealistic, but perhaps the step-up isn’t unrealistic. Look at the dramatic impact that we’ve had on the money multiple on the target return. So if we want to understand why the credit crunch happened, or one of the causes of the credit crunch; if we’re… if we’re saying that one of those causes was too much debt, I think here we’re understanding why banks were under so much pressure to lend to businesses; because for the equity holders, the private equity firms, has a huge, huge impact on their returns.

The power of leverage

Right, well look; let’s have a look at one of the other… are there any questions on that? OK. So we’re learning about money multiples, measuring returns; we know it’s all about buying low and selling high. We’re learning about issues for private equity with this timeframe stretching out, stretching out; we’re learning about that. The other thing that we’re learning about is the power of leverage and the… perhaps the role that’s had in gearing up businesses pre-credit crunch.

Calculating return: IRR (Internal rate of return)

Training course provider: The other main way of measuring return for private equity is internal rate of return, and I just want to… because it is such a common one I just want to make sure we’ve got that one sorted. Internal rates of return. David, here we’re… here we’re imagining that what we’re going to do, to calculate the IRR on our investment, I want you to imagine that I’ve got… I’m putting twenty million in the bank. I’m putting twenty million in the bank and I’m going to turn that twenty into sixty in five years time, OK? So here we go; IRR – let’s try and work it out. So I’m going to put my twenty in the bank and it’s going to turn into sixty somehow. And the IRR, if you like, is answering the question ‘what’s the interest rate?’ ‘What’s the interest rate on that twenty?’ OK. IRR. What’s the interest rate?

Now if I put my money in the bank with your bank at the moment, what kind of interest rate will I get?

Delegate: Two percent.

Training course provider: Two… two percent or something?

Delegate: Something like that.

Training course provider: Something not very high, but I think Matt already knows we know that private equity on their investments are going to be looking for something that’s much, much higher. So David, compounding that twenty up. Twenty plus one… sorry twenty times one plus our interest rate – we know it’s not going to be two percent, it’s going to be something much, much higher – how many years did I say I wanted to do that for?

Delegate: Five.

Training course provider: Five. OK. So here we go. I’ve turned that… I’ve created a little equation on the board there; I’m compounding up my twenty by an interest rate. I’m multiplying by one plus my X percent for five years. That’s going to turn into sixty at the end of the five years; what I want to solve for is the X percent. Ollie, I don’t even need to ask you because you’re a lawyer – algebra? A long, long time ago for you?

Training course provider: And you’d have to have been… have seen this before and used to using it. For most of us there’s some nice little shortcuts within Excel because Excel helps us with some of this stuff; there is an IRR formula in there. But just to understand what IRR is; the IRR is that X percent. Matt, do you know how you’d solve that? Is algebra a long, long time ago for you as well?

Delegate: Er, I did it once; it’s the fifth root of…

Training course provider: The fifth root. OK, well let’s do it; let’s go because we’re having so much fun here with this algebra.

Training course provider: And has somebody got a calculator in the room? No? No?

Delegate: I’ve got a Blackberry if that’s any use.

Training course provider: You’ve got a Blackberry; that’s a bit too hard.

What is IRR?

Training course provider: I tell you what, I know what the answer is because I’ve worked it out before, but this is how we’d do it with the maths. What we do is we take this sixty, divide it by the twenty. That’s what you wanted to do?

Delegate: Yeah.

Training course provider: Correct? All right. And then we take that to the power of one-fifth, so we’ve taken the five over the other side. And the last thing that we need to do is subtract the one, is subtract the one. Yeah. And in fact, because we’re having so much fun, we need to get our computers fired up anyway; why don’t we try building that into an Excel? Just because this IRR thing is so darn important to the private equity firms, if you end up modelling buy-outs what you end up doing is modelling the equity in – which is the twenty; modelling the equity out – which is the sixty; you end up modelling those in Excel and calculating the IRR. So let’s just try.

Right, so if you build that up in Excel, we build that function up, we end up with 24.6 percent. What we can see is that as well as measuring returns, some kind of multiple of equity in and equity out, the other way that we can look at it is by an IRR.

David, here’s a test for you – I know I’m keeping you on your toes; a test for you, David. If somebody said to you that they wanted to triple their money in five years. If they said they wanted to triple their money in five years – turn their twenty into sixty – what sort of IRR would that be?

So here we go, we’ve got a private equity firm who’s telling you they want to triple their money; they’re going to want to do it over the five year period; what kind of return… it’s not going to be two percent they want on their money; what kind of return are they going to want? Twenty-five percent. So a three-times money multiple over five years translates to twenty-five percent. When people are talking to you about money multiples, wanting to triple, double, triple their money, this obviously is translating to very high rates of return. Much higher. So these private equity guys want a much higher return than for example putting your money in the bank. One of the things that’s driving that for them is leverage. Is leverage; and I’m not going to make you do this one, but I’m sure you can guess – if they’ve got a little bit more leverage into the deal. If they got a little bit more leverage into the deal, just as we saw previously, their money multiple would go up and also their IRR would go up dramatically as well, OK.

So let’s… let’s break for coffee.

Summary of the course so far

More private equity training course material

The introduction to private equity course continues by examining the modelling framework firms use when calculating returns.