You Can’t Eat IRR

Throughout my career, I was raised in the private equity model. Buy underperforming assets, improve them as affordably and quickly as possible, and sell them as soon as the market is receptive. This model rewards speed and value engineering. By digging deeper, you see that the primary driver is the internal rate of return (IRR).

Most private equity funds operate with a model that rewards them for getting high IRRs. For example, they receive their pro rata share of returns on their co-investment up to an 8% IRR, and then receive 20% of any cash above that amount. So, if their co-investment is 10%, their share of profits over 8% IRR is 28%. The 10% co-investment is diluted to 8% plus the 20% promoter share.

IRRs are incredibly sensitive to timing. The buy-fix-flip model works great for juicing returns, especially when there’s a robust buyer pool on the back end.

The problem is that this model breaks spectacularly when timing is wrong. Post-pandemic multifamily vintage deals are a great example of this. They were acquired using very cheap debt, but they couldn’t get the deal done fast enough to catch the greater fool. When interest rates started rising again, many sponsors just couldn’t refinance or sell to recover the deal.

This is why I shifted my underwriting perspective from 3-5 year holds to 7+ year horizons.

The next buyer doesn’t matter as much when you’re underwriting an asset based on solid fundamentals and cash flow potential. Holding an asset with proven productive capacity will be attractive regardless of where we are in the business cycle. This level of comfort also allows you to optimize for inevitable market adjustments and execute opportunistic transactions.

For my investments, I’m looking for partners who share this worldview. While the IRR model is attractive for incentivizing the sponsor in high-risk opportunistic deals, it doesn’t align interests and risk as well as a model that prioritizes cash flow. In this case, I prefer deals that offer a promoted return to the sponsor, above a certain multiple on invested capital (MOIC) or an annual equity yield.

What do you look for in a syndication?