How should you measure investment returns? This should help you decide. The pricing of private securities is obscured by several factors: each is unique, analyses available for public securities don’t exist privately, and easy comparisons don’t exist.
Let’s make sure that, when we’re talking about a Return on Investment (ROI, return or yield), we’re saying the same thing. It’s important to understand the differences between an Internal Rate of Return (IRR) and alternative methods for determining the return and why one might be better suited over the other.
While IRR is the standard against which returns are measured by investment professionals, other measures have their place, since you can’t “eat” an IRR (see below). Here are the most common ways to measure investment returns, starting with the easiest and finishing with IRR.
- Cash-on-cash Return – As the name suggests, this is a money-in / money-back calculation with no allowance for the time the capital is committed to the investment. You simply divide the money you eventually get back (principal plus any additional form of cash or other consideration) by the amount of money you invested (the principal). Cash-on-cash returns are expressed as a multiple of the principal (e.g., “I got back 5.5X,” or “I made 5.5 times my money.”
- Simple interest return or geometric average – Again, it’s easy to calculate. You take the total investment income (only the income) over the life of the investment, divide this figure by the principal invested, and then divide this result by the total return of the investment (years or a fraction of a year). This is expressed as an annualized percentage rate, such as 14.2%. Straight-line calculations (simple interest returns) are useful for estimating what an investment delivers over a short period (less than one year). They aren’t adequate for multi-year investments given the “time value of money” considerations. For example: Are the returns received early on, consistently over the life of the investment (through the note’s interest payments), or at the end of your holding period (a capital gain of longer than one year)? When is the principal you invested actually returned – over time (amortization for debt investments) or as a note’s bullet maturity or a stock’s redemption at the end of the investment? These considerations make IRR the best standard of measurement for most longer-term investments.
- Internal Rate of Return (IRR) – IRR should be the form of yield you use to evaluate private investments (with a few caveats below), because IRRs account for the timing of the returns you receive, which vary significantly from one private investment to another. Put another way, it’s a way to contrast what you may receive in the future versus doing nothing (“staying in cash”). Importantly… you should know (most people don’t) that this assumes that the “reinvestment rate” for returns received during the investment period also equals the IRR, which, for a higher yielding investment (say, greater than 10%), is probably unlikely, so the IRR calculation isn’t perfect. But it’s still arguably the best ROI measure there is. If you really want to become an expert, read the investment classic, “Inside the Yield Book” by Liebowitz, Homer, Kogelman and Bova.
Another important note: IRRs can be very deceptive, since an IRR much better reflects risk/return for longer investment periods than for very short ones. For example:
- A 2-percent return, achieved through a cash payment over a 30-day investment, is a 24% IRR (again, IRRs are reported on an annualized basis) – but it’s still only a 2% cash-on-cash return.
- You took 100% of the risk in making the investment but only made a 2% cash-on-cash return!
- Contrast that to a one-year investment with the same monthly returns (12 in total), where you took the same 100% risk upfront but actually received a 24% cash-on-cash return.
Be sure to ask questions, such as whether the equity dividends (or the loan’s accrued interest) compound. Or is the loan principal repaid over time or at the maturity. Ask whether warrants come with the equity or debt investment. Are they detachable?
Various factors (stage of the issuer, type of security, and investor competition) will ultimately drive a private placement’s return on investment. The variety of structures, e.g., venture capital, private equity, senior debt and subordinated debt, underscores that IRRs, in most cases, are the best way to compare one investment alternative to another.
For more information about returns on investment and the typical ranges of ROIs appropriate to particular security types, we recommend you review “?).”
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