Internal Rate of Return Is Misleading You!

Why asset managers, operators and capital allocators are focusing on the wrong underwriting metrics when choosing which projects add to their porfolio

Abstract

Oil & Gas firms often tout investment metrics that center on the Internal Rate of Return (IRR) as the principal metric for underwriting projects to be included in their portfolios. We at Sandstone Asset Management argue that optimizing based on IRR might not be the most strategic approach for privately backed oil and gas firms. This metric in practice has three key shortcomings:

1. IRR assumes a reinvestment of cash flow at the IRR rate – which under a syndicated oil and gas model is difficult if not impossible to achieve since cash flow is designated for dividends not reinvestment.

2. Capital outlays are generally assumed to take place all at point, which bores liltle resemblance to actual cash outlays.

3. Portfolio level loads significantly impact the final IRR’s realized by LP’s.

This metric, while useful for evaluating the efficiency of a single investment netted to the general partner, fails to tell the full investment story. Since most syndicators in the oil and gas space pool capital via GP/LP fund structures, single well IRRs can grossly overstate the economic viability of a well when it is layered into a portfolio. These oversights can lead to suboptimal project selection, as many privately backed management GP’s fail to modify these underwriting metrics to the portfolio level, making projected returns harder to obtain through single well economic screening.

We propose a shift towards utilizing Discounted Multiple on Invested Capital (Discounted MOIC) as a metric that could offer a more comprehensive assessment of a project's profitability under portfolio level loads. This analysis highlights the limitations of relying solely on IRR and demonstrates how Discounted MOIC could lead to more optimized portfolio selections for privately backed firms in the oil and gas industry.