2 Private Equity Calculations to Help You Better Understand Your Retirement Portfolio
Private equity offers the potential for higher returns than public stocks and bonds, but these investments are also known to carry a higher risk profile. Furthermore, projecting cash flows and rates of return on private equity investments is notoriously difficult even for seasoned investors.
Unlike traditional stock financial statements, private equity views a particular fund’s performance using two metrics. These two metrics are the internal rate of return (IRR) and the equity multiple (EMx). Understanding how these two calculations work can help you assess how particular private equity projects may or may not fit into your diversified portfolio.
Internal Rate of Return
The internal rate of return (IRR) is a calculation used to estimate the profitability of a project in a given timeframe. It’s useful both for private equity companies to forecast projects and for investors to evaluate private equity investment opportunities.
The IRR is a discount rate — which expresses the time value of money to estimate whether a project is financially viable — that makes the net present value (NPV) of the project equal to zero. In simple English, the IRR is the anticipated compound annual rate of return that will be earned on the project.
Here’s How the IRR Is Calculated
The NPV is set to zero in order to get the discount rate (the IRR). Because the initial investment represents an outflow of cash, it will always be negative in this calculation. Subsequent cash flows may be positive or negative depending on the project’s profitability or future capital needs.
Calculating the IRR depends on trial and error, so it’s easiest to do using software such as Excel, Google Sheets, or another program that can perform the calculation iteratively.
Case Study: What the IRR Means for Your Portfolio
Carlos is a wealthy investor who is interested in investing $30,000,000 of his retirement portfolio into private equity. He learns of an opportunity to invest in the acquisition of a company called Aspen Capital which specializes in commercial real estate development. To evaluate this opportunity against others he is considering, he performs an IRR calculation to project the potential investment returns.
His calculation for the Aspen Capital investment results in an IRR of 24.7%, which represents the expected return that his initial investment will earn over the life of the project. This number is composed and weighted by two factors. The first is the annual cash flows from the investment. The second is the net proceeds from the projected future sale date of the properties. Assumptions for both factors are based on the historical performance of similar projects.
While IRR is useful for individual investors, it’s also usually the first calculation private equity firms use in deciding whether to move forward with a particular project. It is compared to the hurdle rate or minimum return for investment consideration. Some firms indicate actual vs. projected IRR in their annual statements. It makes for interesting reading to measure the accuracy of the initial projections.
Equity Multiple
The other metric commonly used to analyze a particular private equity investment is the equity multiple, or EMx. The EMx shows how much an investor earned on their capital over the entire lifetime of the investment. This calculation is particularly useful for real estate and private equity investors since the hold time for such projects is relatively longer compared to other asset types.
Here’s How Equity Multiple Is Calculated
This simple calculation divides the sum of all the capital inflows/distributions by the sum of all the capital outflows/contributions. Below is the formula for this calculation.
Case Study: What the Equity Multiple Means for Your Portfolio
Returning to the example above, Carlos learns that Aspen Capital is projecting a dividend yield of 7.5%. The private equity firm acquiring the company plans to sell the company in 10 years with a projected profit of $3.8 billion. Based on this information, they are estimating an equity multiple of 2.1. This would mean that investors would more than double their investment.
However, the EMx does not take into consideration the time value of your investment, nor does it factor in risk and other variables. So if a particular project is projected to span multiple decades, a high EMx may not actually be that impressive as it does not account for things like inflation and risk.
Pairing the Internal Rate of Return With the Equity Multiple
On its own, the equity multiple can help you estimate (or retroactively reveal) the absolute return on an investment. But it doesn’t take the timeframe into account. So while a project with a 3.8 EMx might sound compelling at face value, it may not be that great of an investment if the project won’t be complete for 40 years.
The IRR, on the other hand, can reveal important information about the time value of money, but it is unable to measure the absolute return on an investment. As with EMx, the IRR cannot reveal the full picture on its own.
Paired together, IRR and EMx calculations can help you gain a better understanding of a particular project’s true return over a given time period. The IRR will take into account the duration of the project and indicate its annual rate of return, while EMx can reveal the absolute gain of an investment overall.
Analyze Your Private Equity Investment Opportunities with the Help of Chicago Trust Administration Services
Private equity investments require complex research and evaluation, but we believe they make up an important component of wealthy individuals’ retirement strategies. At Chicago Trust Administration Services, we can help you understand how to complete these calculations (and more) so that you truly understand the role your private equity investments play in your portfolio.
Additionally, we help our clients complete private equity deals in a fast and timely manner using tax-advantaged retirement savings. To see how we can help, we invite you to schedule a complimentary meeting with us by calling 312-869-9394 or emailing steve@ctasira.com.
___________________________________________________________________________
*The content and opinions in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
**CTAS professionals are not financial advisors and cannot provide advice or recommendations regarding specific investment decisions.