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The computation of traditional investment returns is not easy, but it is far easier than the computation of returns for some alternative investments. A main challenge with the analysis of some alternative investments is the lack of regularly observable market prices. Some alternative investments, such as private equity and private real estate, are analyzed using an internal rate of return approach. This approach has numerous potential complications and shortcomings. With the advantage of regular market prices, traditional investment analysis usually computes return as the change in price, net of fees, plus cash flows received (such as dividend or interest payments), divided by the initial price:

(3.8)

However, complications arise when prices cannot be regularly observed or when cash flows are received during the interim period, between the starting date and the ending date of the return observation. A major complexity related to these interim cash flows is that it is unclear how much return could be earned through their reinvestment. It is usually assumed that the intervening cash flows are reinvested in the same underlying investment, but this requires an interim price of that asset at the same time as the cash flows become available for reinvestment.

Since prices can be observed at least on a daily basis for most traditional investments, daily returns are easily computed from daily prices and daily cash flows. Returns over time periods in excess of one day with intervening cash flows can be computed as the accumulation of the daily returns within the time period. In other words, returns for longer time periods are formed from the daily returns of the days within the time period. Returns over time periods shorter than one day do not tend to have intervening cash flows, since dividends and interest payments are usually made on an end-of-day basis.

Despite challenges faced with various compounding assumptions and intervening cash flows, the returns of most traditional investments are made relatively straightforward when daily prices are available. However, return computations for investments that cannot be accurately valued each day generate challenges that are a primary topic of this chapter. For example, securities that are not publicly traded, such as private equity, do not have unambiguous daily valuations that can be used to compute daily returns. This section explains the application of the internal rate of return method to alternative investments and details the potential difficulties with interpreting and comparing internal rates of return.

3.3.1 Defining the IRR

The internal rate of return (IRR) can be defined as the discount rate that equates the present value of the costs (cash outflows) of an investment with the present value of the benefits (cash inflows) from the investment. Using the terminology and methods of finance, the IRR is the discount rate that makes the net present value (NPV) of an investment equal to zero.

Let CF₀ be the cash flow or a valuation related to the start of an investment (i.e., at time 0). CF₀ might be the cost of an investment in real estate, or in the case of private equity, CF₀ might be the initial investment required to obtain the investment or meet the fund's first or only capital infusion; CF₁ through CF_T–1 are the actual or projected cash inflows if positive and cash outflows if negative, generated or required by the underlying investment. Positive cash flows are distributions from the investment to the investor, and negative cash flows are capital calls in which an additional capital contribution is required of each investor to the investment.

A CF_T may be the final cash flow when the investment terminates, the final cash flow received from selling or otherwise disposing of the investment, or a residual valuation, meaning some appraisal of the value of the remaining cash flows related to the investment. In the case of an appraised valuation of CF_T, the valuation should be designed to represent opinions with regard to the amount of cash that would be received from selling all remaining rights to the investment. The values are denoted here with the variable CF, which usually stands for cash flows, even though they may be hypothetical values or appraised values for the investments rather than actual cash flows.

Given all cash flows and/or valuations from period 0 to period T, the IRR is the interest rate that sets the left-hand side of Equation 3.9 to zero:

(3.9)

Another view of the IRR is that it is the interest rate that a bank would have to offer on an account to allow an investor to replicate the cash flows of the investment. In other words, if an investor deposited CF_t in a bank account at time t for each CF_t < 0 and withdrew CF_t from the bank account when CF_t > 0, and if the bank's interest rate on the account was IRR, then the bank account would have a zero balance after the last cash flow was deposited or withdrawn (CF_T).

3.3.2 Computing the IRR

In some simplified cases, such as investments that last only a few periods or investments in which most of the cash flows are identical (i.e., annuities), the IRR may be solved algebraically with a closed-form solution. In cases involving several different cash flows, the solution generally relies on a trial-and-error search performed by an advanced financial calculator or computer.

A simplified example to illustrate the trial-and-error method involves an investment that costs $250 million and lasts three years, generating cash inflows of $150 million, $100 million, and $80 million in years 1, 2, and 3, respectively. The IRR is found as that interest rate that solves the following equation:

(3.10)

The trial-and-error process selects an initial guess for IRR, such as 10 %, and then searches for the correct answer: the IRR that sets the left-hand side of Equation 3.10 to zero. Inserting IRR = 0.10 (10 %) into Equation 3.10 generates a present value of inflows equal to $279.11 million and a value to the entire left-hand side of $29.11 million. The objective is to have the value of the left-hand side of the equation equal to zero. In the case of this investment, a higher discount rate will generate a lower net value. If the next guess is an interest rate of 15 %, the value of the left-hand side of the equation declines to $8.65 million. The process continues with as much precision as required. The IRR of this investment is 17.33 % carried to the nearest basis point.

Advanced calculators and computer spreadsheets perform the trial-and-error process automatically. This solution of 17.33 % for the IRR can be found on most financial calculators by inserting the cash flows (using cash flow mode) and requesting the computation of the IRR or in a spreadsheet with a function designed to compute IRR.

In this example, the trial-and-error process for finding the IRR works well because any increase in the discount rate lowers the present value of the cash inflows, and any decrease in the discount rate raises the present value of the inflows. The solution to the IRR problem is illustrated in Exhibit 3.1.

Exhibit 3.1 The Solution to IRR in a Simplified Investment

Because the IRR is the discount rate that sets the NPV of the investment to zero, the IRR is represented by the point at where the NPV curve crosses through the horizontal axis. This occurs between 17 % and 18 % on the figure, which corresponds to the previous solution of 17.33 %. There is only one solution, and it is quite easily found. If a bank offered an interest rate of 17.33 %, then an investor could deposit $250 million, and withdraw $150 million, $100 million, and $80 million after one, two, and three years, respectively; and the final account balance would be $0, ignoring rounding errors.

3.3.3 Interim Valuations and Four Types of IRRs

The primary reason for using the IRR approach is that regular valuations of the investment, such as daily market prices, are not available. An IRR can be performed on a realized cash flow basis or an expected cash flow basis. A realized cash flow approach uses actual cash flows through the termination of the investment to compute a realized IRR. An expected cash flow approach uses expected cash flows projected throughout the investment's life to compute an anticipated IRR. An IRR may be computed during an investment's life using both realized cash flows and either a current valuation or projections of future cash flows.

There are four types of IRRs based on the time periods for which cash flows are available. Although these terms are not uniformly defined in practice, they are useful for our purposes:

1. LIFETIME IRRS: A lifetime IRR contains all of the cash flows, realized or anticipated, occurring over the investment's entire life, from period 0 to period T. In other words, if in the context of Equation 3.9, time period 0 is the inception of the investment and time period T is the termination of the investment, then the IRR is a lifetime IRR.

2. SINCE-INCEPTION IRRS: A since-inception IRR is commonly used as a measure of fund performance rather than the performance of an individual investment. The cash flows that would then be used in Equation 3.9 are aggregate cash flows of a fund rather than a single portfolio company. The terminal (time period T) cash flow in this case is the appraised value of the fund's portfolio at time T rather than a liquidation cash flow. Interim cash flows represent actual fund-level cash flows from liquidated investments.

3. INTERIM IRRS: The interim IRR is a computation of IRR based on realized cash flows from an investment and its current estimated residual value. The key to an interim IRR is that generally T would not be the termination of the investment; thus, CF_T is an estimated value rather than a realized cash flow. The interim IRR can be calculated on an investment purchased subsequent to its inception.

4. POINT-TO-POINT IRRS: A point-to-point IRR is a calculation of performance over part of an investment's life. All cash flows are based on realized or appraised values rather than expected cash flow over the investment's projected life. Although any IRR is calculated from one point in time to another, a point-to-point IRR would typically not be used to refer to a lifetime IRR.

For IRRs computed over a time interval that begins after the investment's inception, the cash flow in time period 0, CF₀, would be either the first cash flow paid by an investor to acquire the investment or some valuation after the investment's inception, such as an appraisal. For IRRs computed over a time interval that ends prior to the investment's termination, the cash flow in time period T, CF_T, would be a valuation such as an appraisal or the sales proceeds at a date prior to the investment's termination. Three applications follow to illustrate lifetime, since-inception, and point-to-point IRRs.

APPLICATION 3.3.3A

Investment A is expected to cost $100 and to be followed by cash inflows of $10 after one year and then $120 after the second year, when the project terminates. The IRR is based on anticipated cash flows and is an anticipated lifetime IRR. The IRR of the investment is 14.7 %.

APPLICATION 3.3.3B

Fund B expended $200 million to purchase investments and distributed $30 million after one year. At the end of the second year, it is being appraised at $180 million. The IRR is a since-inception IRR and is 2.7 %.

APPLICATION 3.3.3C

Investment C had been in existence three years when it was purchased by BK Fund for $500. In the three years following the purchase, the investment distributed cash flows to the investor of $110, $120, and $130. Now in the fourth year, the investment has been appraised as being worth $400. The IRR is based on realized cash flows and an appraised value. The IRR may be described as a point-to-point IRR and is 15.0 %.