If there’s an iconic badge for private equity valuation this is probably Coller Capital’s IRR and compound interest “cheat sheet” Card.
Most of the industry’s participants are likely to have relied upon this handy tool, the shape of a credit card before it became an app, to perform some quick calculations to estimate the performance of a fund or to price an asset.
As with any cheat sheet, the ability to deal with the nuances of the quick reference notes makes all the difference so that they are not lost in translation.
In the case of Coller’s IRR Card, the all-encompassing nuance is that the calculations on both sides of the plastic badge refer to bullet transactions, i.e. transactions with no interim cash flows as in the case of zero-coupon bonds.
Zero-coupon securities are in fact the only case in which IRRs and compound interests coincide: 20% is both the interest compounded for 5 years that produces a multiple of capital of 2,5x and the IRR implicit in the same transaction.
Because of the coincidence of the results, in the IRR-dominated private markets’ industry, the further derived nuances differentiating between the two sides of the card are at risk to be lost in translation.
- The not easily explicitable reinvestment risk notion (i.e. the risk run by investors for not finding attractive reinvestment rates for early cash-flows) of the compound interest side is overshadowed by the simple implicit (self-) reinvestment assumption of the IRR;
- The notion of duration (i.e. the time and capital-at-risk compression allowed by distributions) of the compound interest side is confused with the “flat time” theoretically possible in the zero-coupon context of the IRR.
These “zero-coupon” nuances of the IRR Card have important pricing implications for investors – with those inattentive among them at risk of being more subtly fooled by IRRs with more penalizing valuations :
- Compound interests and IRRs could mistakenly be considered as substitutes seemingly causing cost of capital and discount rates to artificially raise;
- Timing of cash flows may not be coherently adjusted to (seemingly shorter) durations.
Investors may want to take a second look at prices. Clues for improvement are already in the cards…