As institutional investors move further into private partnerships to outperform their public alternatives, the use of the internal rate of return (IRR) as a measure of performance is gaining wider acceptance. Admittedly, this metric has some serious limitations and just by itself, it cannot provide an accurate representation of performance. But its increased acceptance also means a growing demand for different IRR variants, such as a variant that accounts for the currency results that are gained from investing in a global market.
The IRR is the rate of return that sets the net present value of all cash in and outflows of an investment equal to zero. Next to performing the IRR calculation on a portfolio, similar calculations for a portfolio’s benchmark, have now been well established. On top of looking at portfolio cash flows, this calculation makes use of a benchmark’s public market equivalent (PME). In addition, investors may use a PME+ method to accommodate for calculation problems when the portfolio outperforms its benchmarks and the benchmark value drops below zero. Local IRR and local PME numbers are, like net-of-fee IRRs, variations on the same idea.
To prevent incurring future losses or gains as the result of changes in the exchange rate, investments in a foreign currency may be hedged.
Investing in a multi-currency environment
The universe of IRRs can be further extended with a hedged version, a type of IRR that proves to be useful when investing in a multi-currency environment. To better understand this calculation, the concept of virtual hedging needs to be explored first.
To prevent incurring future losses or gains as the result of changes in the exchange rate, investments in a foreign currency may be hedged. A virtual hedge is a mathematical tool with a similar function. A virtual hedge makes the return on an investment immune to currency movements. By adding a virtual hedge to the return on an investment, a virtually hedged return that reflects the immunized outcome is created. The virtual hedge is best understood as: ‘the return that would be obtained from opening and terminating a currency forward, with a notional that perfectly offsets the foreign investment position’.
Calculating a hedged IRR
The technique of virtual hedging can also be used when estimating the IRR for a foreign private investment. In addition to taking the portfolio cash in or outflow as input, the virtual hedge return over the period between cash flows needs to be determined. This hedged return can then be applied to the start-of-period market value to get the periodic unrealized virtual hedge result. The sum of these periodic hedge results is then added to the residual value of the investment, which is the final cash flow in the calculation. This technique of creating a synthetic end-of-period market value is indeed very similar to the PME technique. Applying the standard IRR calculation to the portfolio cash flows and the synthetic residual value allows to determine an IRR that contains an immunization for unforeseen currency movements.
For more information on how Ortec Finance can help you apply this method, please send us your questions.