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Why focusing on IRR and CoC can harm you as an LP

Happy Wednesday! 👋

I hear from LPs weekly who filter deals by IRR or other similar metrics. Why should you spend time looking at the 12% IRR deal, when you have another one in your inbox that is 30%… right?!

Wrong.

In the vast majority of cases, I think these filtering mechanisms are risky (to the LP) at best and can cause serious principal losses at worst.

Today I’d like to explain why I have such a strong stance on something that seems fairly standard practice among retail LP investors.

Let’s dive in:

The Pitfall of Single Metric Focus

First, let’s establish why an overemphasis on IRR and CoC (Cash on Cash) is a faulty filtering mechanism for a retail LP.

• Overemphasis on IRR:

• Issue: Relying solely on IRR might filter out conservative GPs and let aggressive ones “through” the filer

• Consequence: LPs who don’t get many opportunities may inadvertently take on more risk by choosing to invest out of a “pool” of GPs that tend to be more aggressive in their underwriting assumptions

• Missed Opportunities: Conservative deals with potentially better long-term outcomes on a risk adjusted basis will likely be overlooked

• Overemphasis on CoC Return:

• Issue: Filtering deals based solely on high CoC Return can favor investments with higher short-term returns but potentially higher overall risks or lower long-term growth.

• As a side note, always look out for how cash distributions are made - just because the LLC is distributing cash immediately doesn’t mean it’s from the operations of the property… in some cases it’s taken from equity that was fundraised prior to close

• Consequence: This approach might exclude deals with solid fundamentals but lower initial cash returns.

• Missed Opportunities: Investments with strong long-term appreciation (which would certainly include basically all value add deals) potential may be overlooked in favor of deals with high immediate returns

To summarize, if you get dozens of deals from different GPs per day (like an institutional investor or allocator would) and you're just overwhelmed with way too much deal flow, you can certainly use metrics to "filter down" to a smaller set of opportunities. But (!!) most retail LPs don't get that many opportunities and, as a result, what ends up happening is they inadvertently take on more risk by having a bias (or “filtering in”) the deals with a higher IRR.

Now, you might ask - fairly - shouldn’t there be an IRR floor of some sort?! In other words, if a private syndication isn’t at least a x% IRR, I shouldn’t even bother!

I think the answer to that is fairly personal, but I would guide you to 10% as an IRR floor benchmark. For more on this topic, I would recommend reading:

• Why most LP investments won't 2x your money

• Is real estate better than treasuries?

• Going in assumptions as an LP

While we’re on the topic of IRR, I’d also like to make 2 more points that should help you when looking at investment opportunities.

1) The Importance of Understanding Deal Catalysts

When you’re looking at any deal, try to understand at least three catalysts that could significantly impact the presented IRR in a negative way. This helps you understand downside risk, which is critical in syndicated investments.

If you can't fully evaluate these factors (whether due to time or education constraints), it's okay to pass on the deal and wait for one you can analyze more thoroughly. I give you permission to wait, even if it’s hard to keep your cash under your pillow (hopefully at least treasuries!) in the interim. 😊

2) IRR Calculation: A Sensitivity Analysis

Conduct your own IRR calculation to understand its sensitivity as well. Assess how much of the IRR depends on the exit value versus cash flows. In value-add deals, the majority of the IRR often comes from the exit value, which is why it’s critical to ask for sensitivity tables and understand the assumptions behind the exit projections in deals.

Ideally the above analysis is done on the deal that’s in front of you, but I would start by creating a simple spreadsheet with fake numbers so you can understand how small changes to assumptions have outsized impacts on IRR. You will never be able to unsee this and it’ll change the way you look at IRRs forever - in a good way!

So, in summary, by diversifying your focus beyond single metrics and taking the time to understand the catalysts and sensitivities in each deal, you can make more informed, balanced investment decisions.

I hope this was helpful! As always, would love to hear any questions or comments and wishing you a wonderful week ahead.

I advise LPs on existing and potential positions and write articles here weekly on what I see in the marketplace that could help you invest better. You can find me on LinkedIn or Twitter.

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