30% IRR nonsense

Anyone promising a (high) return deserves one tight slap

Many years ago, I started in the private equity business at a frothy time. Seriously clueless, I asked friends who had a head start “What do you look for in an investment?”. With a straight face, they replied “30% IRR”. It was impressive, yet confusing and unhelpful. After a double espresso to fire up my neurons, I recovered to ask “How do you ensure 30%?”. They pointed to a red-eyed, pale kid with a heavy laptop. In a flash, someone threw a red satin sheet over him, whipped out a wand and mumbled an incantation. I didn’t catch all the words, but there was something about a hockey-stick. As the smoke cleared, cell BZ824 was flashing “30.19%”. I needed a stronger beverage.

I naively thought that 30% IRR nonsense died with Lehman Brothers. Silly me. Recently, a fund manager and a wealth manager, both pedigreed, sold an equity fund to an acquaintance, that too a retiree, by promising a comfortable 30% IRR. Institutional investors routinely mention similar promises made by peers. Some even layer this dubious promise with fake sophistication, though a heinous tool called a back-test (here’s a secret: back-test is used only in marketing, never in investing). I wanted to use this essay to address this long-standing bugbear of mine.

How messed up is 30% IRR? Imagine a resolute Mayank Agarwal at his test debut, being interviewed about his goals. If Mayank had nonchalantly said “Triple-digit test average”, that would be less surreal than 30% IRR. In one case, we can at least spot absurdity since we have a frame of reference for batting performance. This is called an ‘outside view’. While this is intuitive in sport where stats are universal, this is surprisingly rare elsewhere in our messy world.

An outside view starts with the premise that no problem is unique. It is merely an instance of a relevant class of problems that have occurred before. Studying that class provides the most reliable odds for the situation at hand. We started with the problem of “What’s a reasonable return for a good investor?”. My peers used a flawed ‘inside view’ to arrive at an arbitrary 30%. Their only basis was “I’m overpaid, so I must be awesome”. Instead, an outside view starts with historical returns of all investors. This forms a basis to calibrate what defines average, good and great? An aspiring investor can then set a goal that is stretch but not ridiculous.

So, what are the stats on investing? A long-run IRR in the high-teens takes one into investing’s hall of fame. Buffett, Munger, Schloss and Simpson ended up in this ballpark. Its cricketing equivalent would be a club with Gavaskar, Dravid, Tendulkar and possibly Kohli as its Indian members. In a relative sense, these hall-of-famers beat the market by 7% or so. India doesn’t have analogous 50-year investing history. However, 15-year mutual fund data suggests that India’s best have fared slightly worse. Mid-teens IRR (or 4% outperformance) is enough to qualify for our hall-of-fame. Moving from hall-of-famers to averages, over 80% of investors in developed markets underperform the benchmark, effectively delivering single-digit returns. Indian averages are slightly better, though deteriorating. Getting back to our original problem, this outside view suggests that even 15% may be a stretch target over the long run. 30% is way beyond Bradman-esque.

[Separately, setting a realistic goal has nothing to do with how to achieve it. But, it’s a start. ]

Analysts and managers would’ve been better off starting with an outside view. Unreasonable expectations made them biased towards dynamic situations, which are better suited for wishful thinking and aggressive forecasts. It made them blind to fine investments because they couldn’t see an illusory path to 30%. Following the maxim “Whose bread I eat, his song I sing”, dodgy promoters and salesy intermediaries incorporated 30% into their pitches. Predictably, this 30% IRR crowd ended up delivering single-digit returns when I last checked.

The outside view has relevance beyond investing, as the following examples show. First, every CEO charges into M&A believing that his chance of success is 100%. Outside view suggests 30% at best. This disconnect is even worse in large ‘transformational’ deals or in diversification into an unrelated area. Second, under-penetrated categories look very exciting at a nascent stage. Early movers in retailing and restaurants were seen as rock stars. An outside view would’ve asked the question “How do these fare elsewhere, where there’s more history?”. This outside view revealed these to be terrible industries where most companies delivered disastrous results. Naturally, most of our rock stars died of drug overdose and their groupies didn’t do so well either. Third, many Indian lending businesses have been jolted by a regulatory shock that neither promoters nor investors expected. An outside view would’ve better prepared them, as lending has always seen heavy-handed regulation, spanning millennia. If you don’t believe me, check out every major religion’s diktats against usury.

Judgment calls in investing and business are entirely about fuzzy odds. Humans seem wired to approach such situations one at a time, making up favourable odds to rationalize their decisions. This tendency to favour an ‘inside view’ may be rooted in illusions of superiority, optimism and control. Viewing ourselves as special people ably solving unique problems is great for the ego. Resorting to an ‘outside view’ is both non-intuitive and humbling. We have to accept that we’re no different than others who trod down a similar path and that we may fare no better. In my experience, an outside view is the most underrated perspective in big decisions. It provides a basis to gauge odds. It grounds us in reality. It sets right expectations, preparing us for setbacks. Most importantly, it keeps us out of big trouble. Without an outside view, we’re oblivious to history.

Let me recap the outside view on investing returns. Most of us fail to beat benchmark returns. Over the long run and after (all) costs, a small fraction beat the benchmark by a modest amount. This outperformance gets even harder if the amount being managed is sizeable. Since historical market returns approach low-double-digits, 15% net IRR over the long run will place any investor in the league of Steve Smith.

Ideally, investors should not promise any specific return. The only commitment that an investor can honour is to adhere to a proven process that increases odds of modest outperformance. Anyone promising a number, let alone one that vastly exceeds 15%, deserves a knee down South, rather than your trust or your money. 

(Originally published in February at https://www.linkedin.com/pulse/30-irr-nonsense-anand-sridharan/)