Skip to main content

The IRR is perhaps the most widely used measurement of return in the world of investing. Yet few realize that not all IRRs are created equal. In buyout deals, for instance, the IRR can be magnified through aggressive debt funding. An IRR obtained in this manner is inferior to one earned from skillful management and value creation. Managers must therefore delve deeper into the components of IRR to better understand the sources of return.

We break down the components of the IRR into three factors:

  1. Operational Improvement – comes from enhancements to the business such as cost reduction and operational efficiency.
  2. Strategic Enhancement – is improvements to the company’s overall strategy such as market repositioning and product innovation.
  3. Leverage – is the return obtained from the use of debt, typical in private equity (PE) deals.

Consider a hypothetical investment by a private equity firm in a company worth $800M. The business was acquired at an equity value of $500M and divested five years later at $1,630M, generating a levered and unlevered IRR of 49% and 31%, respectively. During the holding period, the business took on an extra $100M in debt. No interest or principal payments were paid until exit.

To evaluate the drivers behind IRR, we first compute the business’ baseline performance by compounding the entry cash flow of $100M to year 5. From the table below, we see that this makes up 12% of the 49% levered IRR.

Next, we repeat the step to find the contribution from operational improvements. This is done by compounding the difference between the pre- and post-deal cash flows to the time of exit. The gain generated from these improvement can then be calculated by multiplying the increase in EBITDA of $40M to the 8.0x EV/EBITDA multiple.

Thus far, we have determined that baseline performance and operational improvements have contributed to about one-third (18%) of the 49% levered IRR.

Strategic enhancement is measured through the expansion of valuation multiple during the holding period. We multiply this increase to the final year’s EBITDA (6.5 x $140M), which equals $910M. The PE firm has generated an additional 12% to the 49% levered IRR.

Finally, to calculate the return from leverage, we simply take the difference between the levered return of 49% and unlevered return of 31%.

By breaking down the IRR into its components, we can see that the PE firm contributed only 18% out of the 49% levered IRR, not as significant as one might expect. Furthermore, the PE firm’s contribution was roughly the same as that of leverage, highlighting why debt financing is highly favored in buyout deals.

Another noteworthy observation is the company’s baseline performance, which contributed about one-quarter of the total IRR or almost half of the unlevered return. This underscores an important point – not all PE returns are generated from the skills of the investor.

In corporate finance, a similar analysis can also be conducted to evaluate capital projects such as new production facilities or investments in new ventures. PE investors can also apply the same analysis to assess which funds in their portfolio contribute the most to their returns and why.

As shown, breaking down the IRR into its components can reveal new insights into the various sources of value and the degree to which they contribute to the overall return. Prudent investors, analysts, and managers should pay closer attention to how their IRRs are obtained so as to differentiate between skillful value creation and creative financial engineering.