Case 014Returns attribution and value creationCore

A buyer offers 2.2x for a three-year-old portfolio company today; the plan reaches 3.0x in year 6. The fund has four years of life left and can redeploy at 20%. Hold or sell, and what IRR does each path give?

The situation

The fund bought Tejomay Logistics, a cold-chain operator, three years ago. A strategic buyer has offered a price that returns 2.2x the fund's equity if accepted now. Management's plan, which the deal team believes, reaches 3.0x at the end of year 6, with all the value realised at that exit and nothing in between.

The fund has 4 years of life left before it must return capital. The partners believe new deals can be made at about 20% a year. The LP advisory committee has asked for the analysis.

Your task

Give the IRR of selling now and of holding to year 6, work out what the extra three years actually earn, compare with redeployment, and recommend to the committee.

Quick check

The plan reaches 3.0x. Does holding three more years for 3.0x beat selling for 2.2x now?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Sell. The offer is a 30.1% IRR; holding to 3.0x in year 6 is 20.1% overall, but the three extra years earn only 10.9% a year on the 2.2x in hand. Redeployed at 20%, that 2.2x becomes 3.80x by year 6 against 3.0x from holding. Holding is justified only if the plan can reach about 3.8x, or if there is nowhere to put the money. With four years of life left and a three-year hold needed, the redeployment case has its own timing risk, which the committee should hear.

Step 1What IRR does each path give on its own?

Both are single cash flows, so the IRR is the multiple to the power of one over the years, less one. Selling now: 2.2 to the power of one third is 30.1% a year. Holding: 3.0 to the power of one sixth is 20.1%. The sale has the higher IRR and the lower multiple, which is exactly the shape that makes committees argue, because LPs are paid in rupees and IRR tables are what the fund markets. Neither number answers the question on its own.

Step 2What do the extra three years actually earn?

Picture a flat you could sell today for Rs 2.2 crore or keep for three years and sell for Rs 3 crore. The question is not which number is bigger; it is what Rs 2.2 crore in hand could earn over those three years. From 2.2x to 3.0x in three years is 10.9% a year, the incremental IRRThe return earned only over the extra period, measured on the value you could have taken out at the start of it. It is what a decision to keep holding actually earns. of holding, and that is the number to put against redeployment. The first three years' 30% is already banked whichever way you decide; it should not be averaged into the hold decision.

The relationship
Incremental IRR=(3.02.2)1/3−1=10.9%Redeploy:2.2×1.203=3.80×\text{Incremental IRR} = \left(\frac{3.0}{2.2}\right)^{1/3} - 1 = 10.9\% \qquad \text{Redeploy}: 2.2 \times 1.20^3 = 3.80\times
3.0 / 2.2the extra multiple earned by holding from year 3 to year 6
1/3the three additional years
1.20^3three years of the 20% redeployment rate
What it says in wordsHolding earns 10.9% a year on money that could be earning 20% elsewhere, so the sale and redeployment path ends at 3.80x against 3.0x.
Two paths for the same money from year 3: hold to 3.0x, or sell at 2.2x and redeploy at 20%1.0x2.0x3.0x4.0xYr 0Yr 1Yr 2Yr 3Yr 4Yr 5Yr 6Offer today: 2.2xIRR 30.1%Hold: 3.0x, IRR 20.1%years 4 to 6 earn only 10.9% a yearSell and redeploy at 20%: 3.80xYears 1 to 3:the deal so far
Both paths share the first three years to 2.2x; holding then climbs to 3.0x at 10.9% a year while selling and redeploying at 20% reaches 3.80x by year 6, so the hold gives up 0.80x of the original equity if the redeployment rate is real.
PathMultiple at year 6IRR on the whole dealReturn on years 4 to 6
Sell now, hold cash2.20x30.1% to year 30%
Hold to the plan3.00x20.1%10.9% a year
Sell now, redeploy at 20%3.80x24.9%20% a year
Hold needed to match redeployment3.80x24.9%20% a year
Holding beats selling only if the plan can deliver about 3.8x by year 6 rather than 3.0x, or if the fund genuinely cannot redeploy the proceeds at 20%.
Step 3What do you tell the LP committee?

Recommend the sale, and name the two things that could change it. First, the 20% redeployment rate is a belief, and a new deal signed in year 4 of a fund with four years left may itself need an extension to be realised; if the honest redeployment rate is below 11%, holding wins. Second, the 3.0x is a plan, and the buyer's 2.2x is cash; a plan that has a one-in-three chance of landing at 2.5x instead has an expected hold multiple below the redeployment path by a wider margin. A continuation vehicle, selling the asset to a new fund the same manager runs, is the third option a committee will raise, and it needs a price set by an outside bidder to be fair to the LPs who are leaving.

Where candidates lose it

The usual loss is comparing 3.0x with 2.2x and holding, or comparing the two whole-deal IRRs and selling, without working the incremental return. Only the return on years 4 to 6, measured on the 2.2x in hand, answers the question.

The second miss is treating the 20% redeployment rate as certain. It is the fund's belief about deals it has not yet found, and the fund's remaining life limits how long those deals can run.

What the interviewer asks next

  • The buyer offers 2.2x now or 2.6x with an earn-out in year 5. How would you compare them?
  • How does carried interest change the partners' incentive to hold?
  • The LPs are split: some want cash now, some want the 3.0x. What structure serves both?

Company names and figures are illustrative.