IRR Can Be Useful – If You Know How To Use It

by Michael Roth

In our look at Investment Multiples, we dug deep into the various investment multiple metrics that are commonly used to evaluate fund performance. Alongside multiples, investors frequently consider the Internal Rates of Return (“IRR”) to get a complete view of a fund’s performance. The CFA Institute also requires funds to report the since inception IRR, along with the DPI, RVPI, and TVPI. In this post, I will detail the IRR formula and point out some well known shortcomings with IRR, but also argue that IRR can be a powerful tool in the right situation.

What is IRR?

Formally, IRR is the discount rate that makes the net present value (“NPV”) of a series of cash flows equal to zero. It is a measurement that is commonly used in corporate finance to determine which projects to undertake. So why does private equity use a measure that is most commonly used in corporate finance?

It seems to be a case of choosing the least worst measure to evaluate performance. Since private equity managers have discretion over the timing and amount of cashflows, a time weighted return measure (Market valuet / Market valuet-1 – 1) that adjusts for the impact of cash flows on the calculation is not entirely appropriate. IRR accounts for the timing of cashflows in calculating performance but investors should be aware of IRR’s shortcomings.

What’s wrong with IRR?

The major flaw with IRR is that GPs can manipulate their IRR with early distributions that can inflate a fund’s IRR. The IRR will come down over time but (1) not until after they have raised their next fund and (2) the fund’s IRR will still be inflated barring a dramatic loss in the portfolio.

Underlying this flaw is the fact that IRR assumes the distributions can be reinvested at the IRR rate. For example, Fund Z has an early distribution that results in the fund having at 40% IRR. The calculation assumes that early distribution can be reinvested and continue to earn 40%. Good luck finding investment opportunities that can consistently do that!

The other problem, which is tied into reinvestment issue, is that many investors look at IRR and think of it as a compound annual growth rate (“CAGR”). For example, let’s look at Figure 1 to see the returns for two funds, Fund A and Fund B.

Figure 1. The Misperception of IRR

The last two rows illustrate that annualized return that generates Fund A and B’s multiple in 8.2 years. As mentioned, this is not entirely appropriate since it does not account for cashflow timing. However, it does show you that the 15.6% IRR is an inflated measure and that the right figure is probably somewhere in between.The first three rows are typical fund stats that you would see for any private equity fund. The next row shows you the hypothetical TVPI for a fund that actually generates a 15.6% return annually. Investors that interpret the IRR as such would be disappointed to know that if the fund had actually generated a 15.6% return annually its TVPI would be 3.27x!

Putting IRR in Perspective

The way to make sure you are not misled by IRR is to evaluate it in conjunction with a fund’s TVPI. Figure 2 below illustrates a common scenario that occurs when scouring the market for investment opportunities.

Figure 2. Cashflow illustration

Putting my LP hat back on, I would rather be in Fund A. Both funds are eight years into a ten year fund life and Fund A has distributed more to investors and has actually produced a higher multiple on the money invested with them. The way I see it, the TVPI multiple is the actual return from the fund and the IRR tells you how quickly (or slowly) the GP has been able to generate these returns. As I mentioned, Fund B returned money to investors quicker but Fund A has done a better job of doing their job by generating a higher multiple on the money I invested.Which fund in Figure 2 is better? An investor that only looks at IRR would be indifferent between the two. However, a more sophisticated investor would notice that Fund A’s TVPI is more than 0.5x higher! What the above example tells me is that Fund B returned money more quickly than Fund A. Fund A took a little more than two years longer to make its first distribution but they have actually returned more to investors to date (Fund A’s DPI is 1.5x vs. Fund B’s 1.0x).

While I think investors should be focused on TVPI more than IRR, different investors may have different considerations as they make their private equity investments.

• A fund of funds manager in the first year or two of their fund’s life may want to allocate part of the fund to a few GPs that tend to generate higher IRRs, like a debt fund that has a current income component or a secondary fund. This way, their own funds will look good from an IRR perspective while the rest of their portfolio takes time to mature and (hopefully) generate a strong TVPI.
• An endowment or foundation, with a truly unlimited time horizon, would be more inclined to focus on finding firm’s that generate a higher TVPI over time.

Wrapping Up

Yes, IRR has its drawbacks but it can be useful as long as investors know how to use it. Investors that are more focused on receiving money back quicker or need to meet certain requirements may look to invest in fund managers or strategies that tend to generate higher IRRs. Meanwhile, investors who look to their private equity allocation to generate excess returns should be more focused on the TVPI multiple rather than worrying about how quickly they generate those returns (within reason, of course).