IRR calculates the annual return on capital invested in a scheme. Investors generally seek a minimum IRR ranging between 20-25% per annum.

Representing the total return across the investment period, EM is typically required to be at least 1.4x, reflecting the secured capital multiplied by 1 plus 0.4, securing investment.

An investor will usually consider the higher of the two as a minimum covenant within the terms of the investment agreement.

Understanding these return metrics is pivotal for developers for two key reasons:

1) Each investor will have their own minimum return requirements in terms of IRR and EM. This enables developers to understand how investors determine if a scheme has sufficient profitability for them to support.

2) These metrics play an important role in defining the terms of an investment agreement. They establish a minimum return hurdle for investors, which, upon attainment, may entitle developers to a more favourable profit share percentage, serving as a performance incentive.
Comprehension of these points will allow developers to review term sheets, calculate the capital return required for investors to meet their minimum IRR and EM, and consequently open discussions around the profit share percentage beyond these benchmarks as a negotiation point.

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Waterfall structure including IRR and EM

The waterfall structure below illustrates a potential sequence of repayments and profit share between funders and the developer involved in a project, where an investor provides equity behind a senior debt lender:

1. Repayment of capital and interest to senior lender
2. Repayment of interest coupon to investor
3. Repayment of invested capital to investor
4. Repayment of invested capital to developer
5. Distribution of remaining funds until Investor achieves an IRR of 25% p.a. or EM of 1.5x on the preferred equity: 40% profit share to Investor and 60% profit share to developer.
6. Subsequent profit distribution after hurdle: 30% to Investor and 70% to developer

Mitigating risk of time and cost overruns

Developers must be aware of the impact of delays, particularly under the preferred equity route, as protracted project durations can increase interest coupon costs and the returns required to achieve minimum IRR and EM multiples, therefore diminishing a scheme’s profitability and the developer’s return on investment.

Similarly, cost overruns can undermine profitability. The priority repayment of investors before the developers receive any profits, as shown in the waterfall structure, underscores the significance of managing project costs effectively.

Mitigating these risks involves strategies such as maintaining healthy contingencies; raising equity against schemes with higher profitability; shorter borrowing terms; low to middle-market GDVs; and experienced contractors and delivery teams.

Understanding these metrics and implementing effective risk mitigation strategies are fundamental to achieve desired returns for developers looking to raise equity funding.