IRR return method: reinvestment premise and liability risks

Investment advice for closed-end funds using the IRR return method as the key return indicator.

I. IRR advice by the bank and triggering liability reasons

In one of the most recent judgements of the LG Munich, a bank was sentenced to pay damages because a bank director had, among other things, used the IRR yield method as early as 1994 to solicit investors during an advisory discussion,
without the effects of this method being sufficiently described in the prospectus.

In the eyes of the judiciary, the mere indication of a formula is more likely to prevent the understanding of this yield indication than to be beneficial, since the average investor will not be able to do anything with it.
can. The question of application also arises for bank advisors, who are overwhelmed by a multitude of key figures, of which the yield ratio is probably the most important in the series of tests of investment criteria, because investors also make their decisions mainly on the basis of which form of investment gives them the highest “yield”.

II. The IRR method in detail

1. notional reinvestment interest

In the focus of the yield hunters, conventional bank products are no longer sufficient. It has to be double-digit returns. Here, the bank and also the advising employee must exercise particular care,
because the Federal Court of Justice requires its own plausibility check of, among other things, economic viability and no adviser may rely on the fact that auditors (prospectus auditors) and the employer’s own auditing department have already done this. It is becoming increasingly apparent that knowledge of the internal rate of return (IRR) method is being used in an extremely incomplete and investor-deceptive manner, because its hidden assumptions are not seen through and the investor is given a distorted picture of the profitability of the proposed form of investment.
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This is because of the following:

In financial mathematical terms, the IRR ratio is based on the assumption of reinvestment. In the IRR return measurement
between the capital invested today and the final value at the end of the investment, the additional income from the reinvestment of the investment returns (current distributions and sales proceeds) is automatically included, although these are only fictitiously available. The investor who consumes the returns cannot reinvest them at all (on the same terms), nor can he earn any additional income, as required by the IRR method.

This category includes the vast majority of investors who invest in closed-end funds because they want to use the returns to increase their standard of living.

2. IRR method at best maps the zero bond

The smaller part of the investors will reinvest the reflows in a disciplined way, but at real capital market interest rates at the time of the respective reflows – which is not the theory of the IRR method. This calls for the reinvestment
of each return at the calculated notional IRR return rate, so that the reinvestment rate is automatically assumed according to the desired result of the IRR notional return. The reinvestment therefore takes place at a fictitious interest rate that is far removed from reality. Equally unreal, the IRR methodology requires that this reinvestment rate be enforceable for any residual investment period of returns to the customer, even if it is
so short. Ultimately, the reinvestment interest rate generally applies to all reflux levels.

Results:

Only if the IRR rate of return fully and accurately describes the reality of reinvestment opportunities would the IRR rate of return also be suitable for demonstrating the profitability of the investment series. Theory dreams what reality can never provide; except for zero bonds.

Therefore, the IRR ratio is also not suitable for comparison, which the prospectus contents on IRR repeatedly emphasize. Payment series can only be compared if the original payment series and the competing payment series are projected to the terminal value using a reinvestment interest rate that is the same for both.

This fails in the IRR method because the respective IRR rate of return of the investment series is always used as the reinvestment rate.

3. basic knowledge of financial mathematics

In order to correctly evaluate the IRR method or the alternative capital commitment method (closely related to the MISF = Multiple Investment Sinking Fund) in the investor’s interest, more is needed than the prospectus presentation
with the IRR content. In the brochures, the two methods are usually inadmissibly mixed and misrepresented in short form.

This is easy to notice if, although the determination of the IRR return is made as a (calculation) interest rate that condenses all present values at the time of investment to the value zero, this interest rate is
is presented as the return on the arithmetically average capital employed. Here one has methods of the MISF resp. borrowed from the capital commitment method.

According to the financial mathematical IRR method, the interest rate found represents the return on the IRR capital investment up to the end of the investment (terminal value determination), if all returns at the interest rate found (IRR return rate) are reinvested up to the end of the investment without exception. A real, completed ship investment example is intended to illustrate this and to show that the interpretation of the return ratio as a
There can be no question of a return on an arithmetically average amount of tied-up capital.

4. example of concluded sample ship participation in the combined model

The supposedly so positive IRR return of 17.11% p.a. is only achieved by the reinvestment assumption and melts down to 7.14% p.a. when the returns are consumed, because there is nothing left to reinvest (see Fig.1).
More than 354,329 units of additional income are contributed by the notional implied interest, although only 111,745 units after tax have been returned to the investor over the 10.5 years in addition to the capital invested.

Who does not clear up the investor over these connections of the IRR method, damages not only its reputation and the reputation of the bank, but deceives the investor massively over the true profitability of the fund participation and can face appropriate claims for damages.

III. Liability trap due to lack of investor information

If the IRR method cannot be made sufficiently clear to an investor of average sophistication, the employer of the employed bank advisor is liable for its use if it turns out that the rate of return is
was overstated. Only when one knows the pitfalls of the IRR method can one unmask it and thus escape liability for the false prospectus statements, because one has made one’s own plausibility considerations, to
which the advisors are required to do by the BGH.

It is also pointless to resort to the KBM (capital commitment method) to defend the IRR, which is also subject to the implicit reinvestment premise. Here, fictitious interest is paid on account balances formed from the capital invested and the reflows, using a fictitious interest rate of
17.11% p.a. to end up with an arithmetical capital commitment of zero. Who is willing to pay this fictitious interest on the original cash flows?

Regardless of the type of investment form or investment series chosen, whenever the IRR method is used, the reinvestment premise automatically applies, and thus the excessive
“apparent return” of IRR2.

IV. The courts direct the focus to the IRR yield method

It is not surprising that the imputation of the notional additional interest on considerable claims for damages
of the investor if the IRR return method is applied uncritically. The courts are now on
the best way to expose the implications of the IRR method for the benefit of investors and to expose the moderate yield lie as a drastic yield swindle.

by Dr Johannes Fiala and Dipl.-Kfm. Edmund J.Ranosch

courtesy of

From www.bankpraktiker.de (published in Bank Praktiker, issue 07-08/2007, pages 388-390)

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About the author

Dr. Johannes Fiala
PhD, MBA, MM

Dr. Johannes Fiala has been working for more than 25 years as a lawyer and attorney with his own law firm in Munich. He is intensively involved in real estate, financial law, tax and insurance law. The numerous stages of his professional career enable him to provide his clients with comprehensive advice and to act as a lawyer in the event of disputes.
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