Any good investment starts with planning, foresight, and the necessary research to determine the next opportunity.
Part of that research is to determine what the potential rate of return would be for any new investment, particularly when diving into the world of private equity.
Information can be scarce and investment risk is high in the private-equity space, so you need to have a good understanding of what kind of return you could be looking at by making an investment. You’ll also want information that can be used to compare to an investment in a more traditional asset, such as a factory or an exchange-traded fund.
To decipher this, the Forge team — as well as many other firms that invest in private equity — use a calculation called the Internal Rate of Return (IRR).
Understanding Internal Rate of Return and Net Present Value
According to Investopedia, Internal Rate of Return (IRR) is “a metric used in capital budgeting to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. ”
Investopedia’s definition gives you a great starting point for understanding IRR. However, here’s an additional scenario that can help deepen your understanding: Let’s say you have engaged in a capital-intensive project such as building a factory. You would invest X dollars in capital to get the factory running. Then, every year afterward you would receive Y dollars in value from that factory.
IRR value can then be used to compare the factory to the value of investing that same capital in different projects or funds.
You can calculate IRR based on historical pricing data, which — in the stock market — is not a good predictor of future performance. But, you can use IRR to track the annual growth of a potential investment relative to other projects or funds.
Breaking Down IRR Calculations for Funds
The standard IRR calculation is used when you have a fund, such as an annuity, or the factory that was mentioned earlier. This project has an initial investment, and then it pays out in equal intervals.
The payment intervals could be bi-weekly, monthly or yearly, but the intervals should be standardized to make calculations easier.
For example, let’s say our factory builds New Year’s Eve decorations and only counts revenue on New Year’s Day.
A sample transaction ledger might look like the spreadsheet below for a simple once yearly annuity.
In our factory, we have an initial investment of $500, and every year we get a payout of $300, realizing a $100 gain in two years — resulting in an IRR of 13 percent.
But private-equity market funds are never simple and far from consistent. Private-equity market valuations and transactions usually happen due to late-breaking news.
Note: This is from a fund perspective. Any individual or entity can redeem their fund units at a time they choose, so their personal IRR calculation would be different.
A simple fund ledger for our fund might look something like this.
The Private Equity Example
At Forge, we have multiple funds that are vehicles for private-equity investments — called Equifunds. When you purchase shares of a private company — such as Spotify — through one of our funds, you can purchase fund units in Equifund that pair with the company of your choice.
Equifund also provides “exits” from our fund once a company IPOs. This means that the ledger for our fund will have multiple buy-in times and one full payout.
This allows the fund to not only provide liquidity to the shareholder, but also to the fund investor who can sell fund units before an exit event or IPO.
In this sample Equifund, two investors bought shares in the fund for $500 and $1,000, then when the fund exited it paid $2,500 to all investors.
Before anyone says that this is an incredible rate of return (more than 76 percent), we’ll show that this IRR calculation is on par with the IRR for many of our funds over the same period.
We’ve also introduced the Excel XIRR calculation in this scenario. The standard IRR calculation in Excel is built on the premise that the payments are evenly distributed. To calculate the IRR effectively with varying dates and payments, we need to use Excel’s XIRR which calculates IRR but uses different payment dates.
We’ve described the formula syntax and use of the XIRR function in Microsoft Excel.
This article describes the formula syntax and usage of the XIRR function in Microsoft Excel. Returns the internal rate…
Now it’s time to bring all of this together. In this example, we use real share price data for one of our funds — specifically, Spotify’s Equifund because we were direct contributors to their ability to conduct a direct listing instead of an IPO.
According to our data that spans over six years of private-equity investment, Spotify’s share price on the secondary market made an incredible 10x price — moving from a share price of ~$322 to almost $5,000.
Note that the final number (~$5,000 share) represents their pre-split share price. When they went public, they also had a massive share split that resulted in their direct listing price in the range of $149.
But we’re discussing IRR at a fund level, and this data helps us create a realistic fund that we can use to show a real IRR calculation. Using our new fund, let’s see our old ledger but using market data from Spotify.
Our Sample Fund, Buying One Share Per Transaction
We have changed the amounts to make the calculations easier for our two investors. They each purchased one share of Spotify one month apart and then cashed out right when Spotify listed on the public market.
Over two years — from when the investors purchased and cashed out their shares — they determined that their IRR would be 65 percent.
That’s the awesome power of a private-equity market. Now you can understand why investors are so excited about gaining access to the private-equity market through Forge — to gain access to some of the highest growth companies in the world.
Originally published at blog.forgeglobal.com on January 17, 2019.