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IRR (Internal Rate of Return)
The annualized return rate that makes the net present value of all cash flows equal to zero.
Formula
IRR solves for r in:
0 = ฮฃ (CFt / (1+r)^t)
Where CF includes all contributions (negative) and distributions (positive).
Typically calculated using software/Excel IRR function.
Definition
What is IRR?
IRR measures the annualized return considering the timing of cash flows. Unlike simple multiples, IRR accounts for when money was invested and returned. A 3x in 3 years beats a 3x in 10 years.
IRR vs. Multiple
A 20% IRR over 10 years produces 6.2x. But 20% IRR over 3 years only produces 1.7x. IRR rewards faster returns. Funds optimize for both: high multiples achieved quickly.
IRR Manipulation
IRR can be gamed with early distributions. Returning capital quickly boosts IRR even if total returns are mediocre. Always look at IRR alongside multiples.
Example
Investment timeline:
- Year 0: Invest $1M
- Year 2: Distribute $500K
- Year 4: Distribute $2M
Total return: 2.5x ($2.5M on $1M)
IRR: ~35% (accounting for timing)
Same 2.5x over 8 years would be ~12% IRR.
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