Investors considering investing in a new private equity investment project normally will carefully evaluate any new investment proposition in light of their merits and their risks.
For many private equity investors, investing in real estate or privately held companies, investments will be made and hold over a couple of years until they will be exited again. In such cases, most investors will want to calculate how much return their investment is expected to make and compare it with other alternative investment options. To answer this question, investors need to calculate the Internal Rate of Return (IRR). IRR analysis is one of the most used financial metrics mostly used by professional investors whenever they are considering an investment project with an exit in the near to mid-term.
Many investors are using bank financing for their investments and they mostly think in terms of how much equity will be needed and how at which price they can exit their equity stake again. They will most likely base their investment decision on the expected levered IRR which in many cases is heavily influenced by financial engineering techniques.
In this article, we want to show based on an internal rate of return example that in order to understand the levered IRR, a solid understanding of the IRR unlevered is required as well.
The Difference between IRR levered and IRR unlevered: Financial Debt
The internal rate of return (IRR) calculation is based on projected free cash flows. The IRR is equal to the discount rate which leads to a zero Net Present Value (NPV) of those cash flows. Important therefore is the definition of the free cash flows. There are two main types of free cash flows which can be referred to:
- Unlevered free cash flows (free cash flows to firm): EBIT * (1-tax rate) – CAPEX + Addback Depreciation – Change in Net Working Capital
- Levered free cash flows (free cash flows to equity shareholders): Unlevered free cash flows + change in financial debt – interest + correction for effective taxes paid
EBIT = Earnings before Interest and Taxes
CAPEX = Capital Expenditures
While unlevered free cash flows refer to the cash flows generated by the company without considering its financing structure, levered free cash flows are impacted by the amount of financial debt used. Using financial debt – especially in low-interest-rate environments – is much cheaper than financing solely with equity and allows to enhance the returns on their investment. This is called “financial leverage, “gearing” or “financial engineering”. The resulting IRR calculations now can be differentiated as follows:
- IRR Unlevered uses the unlevered free cash flows and is subject to the operating risks of the company. The unlevered IRR is not supposed to be affected by any change in the company’s financing structure. The IRR Unlevered often is also called the “Project IRR”.
- IRR Levered is calculated based on the levered free cash flows (another variation of this is to use a cash-in / cash-out consideration based on the initial equity investment made, dividends and exit proceeds). IRR levered includes the operating risk as well as financial risk (due to the use of debt financing). In case the financing structure or interest rate changes, IRR levered will change as well (whereas the IRR unlevered stays the same). The levered IRR is also known as the “Equity IRR”.
Calculating and understanding the IRR levered can be tricky. Therefore, let us review an internal rate of return example calculated in Excel for two different investment cases. Both investment projects, A and B, show similar operating risks and require a 10% opportunity cost on invested capital to compensate investors for the operating risks involved.
Internal rate of return Example Project A
Project A is a proposed private equity investment in a manufacturing company. The investment is expected to be exited within 5 years. The company of Project A has $7.5m in sales and a $6m acquisition price is requested. 50% of the acquisition price can be financed through debt which results in a $3m equity investment required. See below the projected financials for Project A.
Internal rate of return Example Project B
Example Project B is a bit bigger and requires a $33m initial investment while showing $42m in annual sales. Project B offers that up to 90% of the initial investment price can be financed through financial debt, therefore requiring $3.3m in equity investment. See below the projected financials for Project B.
Comparing IRR Levered
Available investor funds are limited and are only sufficient to either be invested in Project A or Project B. We, therefore, use IRR analysis to figure out which investment project should be pursued, Project A or Project B.
We start our IRR analysis by calculating the IRR levered based on the levered free cash flows. We then compare IRR levered between Project A and Project B:
Based on our comparison table and our internal rate of return example calculation of IRR levered above, it seems that Project B is better, since it requires almost the same amount of investment as Project A, while offering 30% instead of 20% IRR levered. On first glance this looks great but on second thought we would base our investment decision solely on the IRR levered without actually understanding why IRR levered is higher for Project A than for Project B. Now let us dig a bit deeper in the IRR analysis, as we need to understand why project B is offering us nearly 1.5x the IRR levered compared to Project A.
Understanding IRR Levered by analyzing the effect of Financial Leverage
We are widening our IRR analysis by also comparing the unlevered IRRs of the two investment projects and the degree of financial leverage used. Please find the updated comparison table below.
Now we find that IRR unlevered is better for Project A than for Project B. In fact, the company’s weighted average cost of capital (WACC) lies at 10%, which means, without using financial leverage Project B’s IRR unlevered (7.7%) is not sufficient to pay for its cost of capital. For Project A, IRR unlevered (12.9%) exceeds the company’s WACC (10%). This means Project A actually is a better project than Project B since it offers excess returns beyond the company’s cost of capital without any financial engineering.
The reason why IRR levered is higher for Project B compared to Project A is, Project B benefits from 90% bank financing which increases returns up to 30.4%. The return is heavily driven due to financial engineering. Project A also benefits from financial engineering but only up to the level of 20% levered IRR as only 50% of the project is financed with debt.
Now in the above internal rate of return example still many investors will argue that receiving a 30% return is better than receiving a 20% return. The problem is that they ignore the financial risks involved. They also make the mistake that they exchange a good project for a bad one and without realizing it. Suddenly, they will take on much more risk as the financial risk adds up.
Important to note is that Project B investment proposition has a very different risk profile than Project A. If something goes wrong and the project cannot be exited at the intended exit valuation, Project B’s equity portion will have to absorb a possible hit on the exit valuation and the equity value is in danger of being completely wiped out since only 10% of the initial project value is financed through equity. If you compare this to a worst-case scenario for Project A, where the equity portion is 50% of the initial investment, there is more equity buffer to absorb a possible hit on the exit valuation. Project B becomes riskier due to the high degree of financial leverage (90%) used.
In addition, Project B is lower in quality compared to Project A. In case the project performs worse than anticipated unlevered IRR (7.7%), there is less buffer compared to the IRR unlevered of Project A (12.9%) and Project B’s unlevered IRR in the worst case is more likely to become negative than Project A’s.
Comparing Apples with Apples
In order to neutralize the effect of financial engineering, it is better to compare apples with apples. Therefore, we need to compare the two investment projects with the same degree of financial leverage. This means we need to change the 90% debt financing used for Project B down to 50% (same as Project A). Our Project B (90% debt financing) now becomes Project C (50% debt financing) and shows the following cash flows:
Our comparison table now can be updated. Project C actually is the same as Project B except we are using a 50% financial leverage (and not 90% anymore).
While the equity investment now is significantly higher, we exclude this fact for the moment as we only want to base our decision-making process on IRR analysis. Now we are comparing the two projects with the same degree of financial leverage. The analysis of IRR levered shows that Project A (20.2%) outperforms Project C (11.2%). This means with Project A we get more return for the risk we take compared to Project B, ergo Project A is a more efficient investment proposition in terms of risk. For decision-making purposes, this is the type of analysis to perform.
Conclusion – IRR levered requires an understanding of IRR unlevered
Whenever we are confronted with IRR analysis, it is important to understand what kind of IRR is calculated, IRR levered or IRR unlevered.
When we calculate the IRR levered, as our internal rate of return example shows, we should also calculate the IRR unlevered. We should only enter into investment project where we are compensated for the risk which in this case means, that our investment from an IRR perspective needs to fulfill two conditions:
- IRR unlevered to exceed the WACC (to ensure the project generates an excess return and does not destroy value)
- IRR levered to meet our own specific return target
By adhering to this rule, we can ensure that we carefully pay attention to the risk of investment projects we enter and not unnecessarily end up selecting only bad projects with excessive risks.
Whenever we need to compare investment projects with different degrees of financial leverage used, we can neutralize the effect from financial engineering when comparing the projects “as if” they would use the same degree of financial leverage. This allows us to compare IRR levered as well, as now we compare apples with apples.
The internal rate of return examples above shows what type of analysis is needed to better understand the effects from financial leverage on IRR and avoid a costly mistake when not getting enough return for the (operating and financial) risks involved.
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