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. Cash-on-cash, simple interest, and IRR are useful metrics, but only if you apply them correctly.
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 others.
Here are the most common ways to measure investment returns:
- Cash-on-cash Return – a money-in / money-back calculation with no allowance for the time the capital is committed to the investment
- Simple interest return – the total investment income, divided by the principal invested, and then divided by the term of the investment (years or fraction of year). This is used to estimate returns of less than one year, rather than for multi-year investments.
- Internal Rate of Return (IRR) – the recommended form of yield to evaluate private investments, as the timing of the returns vary significantly from one private investment to another. It’s a way to contrast what you may receive in the future versus doing nothing (“staying in cash”). An IRR better reflects risk/return for longer investment periods than for very short ones. For instance, a 2 percent return over one month is a 24% IRR (because IRR is an annualized metric). However, while a one-month investment of 2% may be an annualized 24% IRR, you would only receive a 2% cash-on-cash return, and using IRR to measure your one-month return would be misleading. Contrast that to a 12-month investment, held for 1 year, that yields an annualized 24% IRR. You took the same risk upfront, but, in this case, you actually received a 24% cash-on-cash return 1
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 IRR’s, in most cases, are the best way to compare one investment alternative to another.
- Importantly… 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. If you really want to become an expert, read the investment classic, “Inside the Yield Book” by Liebowitz, Homer, Kogelman and Bova.