Internal Rate of Return (IRR) – Understand the crucial private equity metric

Are you ready for quite a nerdy article? If not, I’m afraid you’re in the wrong place.

Because! We are about to dive into IRR which is a quite complex metric.

It’s one of the most important metrics when it comes to evaluating your private equity investments, so if you can find your inner nerd, hang on for the ride.

(If you can’t, you can jump down to the key takeaways further down the article, but you'll lose out on important knowledge that demands further explanation.)

In very simple terms, the Internal Rate of Return reveals your average annual return on investment.

But, I’m not much for simplifying.

That’s why I’ll break down this key metric to give you a thorough understanding of what it means and ensure you avoid the common misunderstandings that exist about it.

For those of you who stayed with me, let’s get to it.

Example of overview of investments in four funds

Instead of jumping headfirst into the deep end of the pool, let me begin with showing you an example of an overview of investments in four private equity funds.

These overviews typically include the vintage year, which is the year the fund was established, and the current market value of your investment in each fund. They also state your commitments and unfunded commitments, so you always know how much liquidity you need in order to meet capital calls from the funds.

IRR, DPI (Distributed to Paid In), RVPI (Residual Value to Paid In), and TVPI (Total Value to Paid In) are the four key metrics to use when evaluating your investments.

We’ll give you a thorough introduction to each in our knowledge hub, beginning with this article about IRR.

The overview below also shows you how much capital you already contributed to the fund and how much capital the fund already paid you in distributions.

Now, let's delve into the key metric of this article.

What does the Internal Rate of Return reflect?

The Internal Rate of Return shows the average annual return on the capital invested in the fund at any given time.

The last part – “at any given time” – is central because you don’t contribute your whole capital commitment at the same time. On the contrary, you contribute capital throughout the fund’s lifespan whenever they make capital calls.

As such, your whole commitment to the fund is not invested during the whole lifespan of the fund. Consequently, IRR doesn’t show the average annual return on your total investment in the fund; instead, it reflects the return on the capital invested in the fund at any given time.

The Internal Rate of Return shows the average annual return on the capital invested in the fund at any given time.

This may still sound complicated, but hang on, and hopefully, you will fully understand that sentence after reading the entire article.

IRR is calculated using a relatively complex mathematical formula that considers numerous factors such as the valuation of the companies the private equity fund has invested in, the capital calls you've met and when and the potential distributions the fund has made when selling companies from its portfolio.

At Aleta, we calculate an Interim IRR based on both realized and unrealized returns while the fund is active, and a Final IRR based on realized cash flows after the fund's closure.

While the fund is active, the Internal Rate of Return reflects both the realized and unrealized returns on your investment. In essence, it shows the annual increase in the investment's total value and not just the realized portion.

Given the complexity of the metric, there are pitfalls when it comes to interpreting it. Let’s explore one of them – the assumption of reinvestment.

Be mindful of the assumption of reinvestment

When interpreting the Internal Rate of Return, some people mistakenly do it based on an assumption of reinvestment. Interpreting the metric based on this assumption can distort the actual results the metric is supposed to reflect and make the return seem higher than it actually is. Let me elaborate.

First, let me repeat: Many interpret IRR as representing the average annual return on the total capital invested in the fund; however, IRR reflects solely the return on the capital invested at any given time.

Let’s make a comparison: You have a certain amount of cash in your bank account, and you receive an interest on this money. But you, obviously, only earn this interest for the days the money is actually placed in the account. Similarly, Internal Rate of Return only reflects the return on the capital invested during the period it has been invested. Makes sense?

This is because the calculation considers the cash flows – the inflows and outflows between you and the fund – and their timing. If you interpret IRR as the return on the total capital you’ve invested in the fund, you’ll be assuming that the fund's distributions have been reinvested at a return equivalent to IRR instead of being paid out to you.

It can be explained like this: if the fund has made a significant payout to you relatively early in its lifespan, your amount of invested capital in the fund has been reduced, and IRR is calculated as the return on the capital that is invested during the time that it's invested. Wrongfully interpreting the metric based on an assumption of reinvestment – and thus as the return on the total capital one has had invested in the fund in its whole lifespan – will lead to a distortion in the interpretation of the result. In that case, one would assume that the payout received from the fund has been reinvested at a return equivalent to the IRR.

Consider this example:

A fund has called a total of 10 million from you throughout its lifecycle and achieved a final IRR of 10%. Based on the inaccurate assumption of reinvestment, you’d interpret IRR as an annual return of 1 million on average. However, this is true only if the entire 10 million have been invested throughout the fund's lifespan, which is rarely the case in practice. In reality, you've had an average annual return of 10% on the capital that has been invested at any given time.

Note: Most private equity funds typically calculate Internal Rate of Return from the day they begin investing. This approach excludes the initial period of the fund's lifespan when it hasn't invested in any companies yet, as this period, with a 0% value increase, would unfairly skew the average annual increase in value. However, some funds calculate the metric from the day investors commit, and arguments exist both for and against each approach.

Can IRR be compared across private equity funds?

Since Internal Rate of Return accounts for the time a fund has taken to generate returns, two funds could achieve equal returns measured by DPI (the realized return from the investment) over their entire lifespan but still have different IRRs. The fund that achieved the returns in the shortest time will have the highest IRR.

In principle, the metric is comparable across the private equity funds you've invested as it reflects both realized and unrealized returns and also takes time into consideration. As such, this key metric is very helpful when you want to compare the results of your various private equity investments. However, you should be mindful of comparing funds with different risk profiles.

You should also be aware that the comparability of Internal Rate of Return across private equity funds is contingent upon them calculating the metric on the same basis. For instance, they should either all calculate it from the day you gave your capital commitment, or all calculate it from the day they began investing.

Be aware that the comparability of Internal Rate of Return across private equity funds is contingent upon them calculating the metric on the same basis.

Additionally, pay attention to whether the funds have factored in costs such as management fees in their metric calculation. Costs should be included in your contributions to the funds, as they constitute a part of your total investment expenses. If these costs are not included in the calculations, it’ll inflate the perceived gain from your investment.

Let me show you how a fund's IRR can vary significantly based on how the fund chooses to calculate it. Suppose you invest in a fund, and the following events occur:

In this example, the metric can vary from 6.9% to 12% depending on how it's calculated:

Therefore, it's crucial to investigate how different private equity funds calculate IRR before evaluating and comparing their results based on this metric.

Some funds attempt to optimize their IRR

Given that Internal Rate of Return is the most used metric for evaluating private equity investment results, funds aim to present an impressive IRR. Some funds will do everything possible to report the highest possible Internal Rate of Return.

Apart from using the methods explained above to calculate a higher IRR, funds might start investing with borrowed money before calling capital from investors. If they then calculate the metric from the first capital call from the investors, it’ll look like the fund achieved a certain return in a shorter period than it actually took to develop the invested companies. Consequently, the IRR would be higher than it should be, as it wouldn't accurately reflect the fund's performance.

Funds can also optimize their IRR by returning capital to investors and later recalling that capital. This manipulation shifts the timing of capital flows, and since IRR accounts for the duration the capital has been invested, this practice optimizes the fund's IRR.

To sum up, here are the key takeaways about Internal Rate of Return before I continue with a discussion of which metrics are the best for evaluating your private equity investments.

Key takeaways about Internal Rate of Return

• It's one of the most crucial metrics for evaluating your private equity investment.

• The metric shows the average annual return on the capital invested in the fund at any given time.

• It reflects both the realized and unrealized returns on your investment.

• The calculation of it considers the cash flows between you and the fund and the timing of these cash flows.

• When interpreting the metric, be mindful of the assumption of reinvestment.

• The metric is generally comparable across the funds you've invested in.

• When comparing the Internal Rate of Return of different private equity funds, consider whether the funds have factored in costs such as management fees in their calculation, whether they calculate IRR from your commitment or from the first capital call, and whether they have used leverage in the initial period of their lifecycle or optimized the metric in other ways.

Which metrics are best for evaluating your private equity investments – and are they comparable across different funds?

As mentioned in the beginning of the article, there are four key metrics for evaluating your private equity investments: IRR, DPI, RVPI, and TVPI.

I’m sorry to disappoint you if you expected a definite answer to the question above, but it’s just not black and white.

However, there are compelling arguments for considering IRR and DPI (Distributed to Paid In) as the most valuable metrics. DPI is the ratio between what you have contributed to the fund and how much the fund has paid out to you. Still, each metric has its advantages and disadvantages.

There are compelling arguments that IRR and DPI are the most valuable metrics when evaluating your private equity investments.

Let’s take a look at them.

On one hand, some argue that Internal Rate of Return is the most accurate metric because it accounts for the time the fund has taken to generate its returns. Fund results measured by IRR are theoretically more comparable if the funds haven't existed for the same duration.

However, some believe that the time factor plays too significant a role in the IRR calculation, and the wrongful assumption of reinvestment distorts the metric too much.

It’s essential that the metric be interpreted in context because a high Internal Rate of Return doesn't necessarily indicate good fund performance. This is due, in part, to the fact that it’s a percentage metric, meaning a fund can achieve a high IRR even if it has invested very little capital because the metric only shows the return on the invested capital.

And remember: investors must maintain liquidity throughout the fund's investment period to be able to meet capital calls. If they have no opportunity to gain a particularly high return on the capital that must remain liquid during this period, it becomes problematic for the investor if the fund doesn’t invest a substantial amount of capital. But even so, the fund can have a high IRR if the capital they did invest is growing in value.

Being a skilled private equity fund includes effectively investing the committed capital. Therefore, many may prefer a fund with a lower Internal Rate of Return – but one that has actually invested a significant portion of its total commitment over an extended period – and a higher DPI. This is because DPI doesn't face the same challenges as IRR when it comes to the reinvestment assumption. You can buy bread with DPI; you can't with IRR.

You can buy bread with DPI; you can't with IRR.

Given the interpretation challenges with IRR mentioned above, some prefer to compare private equity fund results based on DPI, even though this metric doesn't account for the time funds spent generating returns.

Another argument for DPI being the better metric for evaluating fund results is the fact that funds take various actions to optimize their IRR. Consequently, a fund may have a high IRR but a low DPI.

Unlike IRR, DPI solely represents the realized return on your investment in a fund.

(At least after the period when the fund can recall distributions has ended. Until then, the fund has the option to recall distributions if specified in relation to individual distributions.)

The choice of which metric is best for evaluating your private equity funds' results also depends on whether you're evaluating the results while the funds are still active or after they've been closed.

One could argue that IRR is the most accurate metric for assessing a fund's performance as long as it's still active. The metric reflects both realized and unrealized returns while considering the time factor. However, pay careful attention to the various pitfalls in interpreting IRR, and remember that the metric must be interpreted in its context.

When a fund is closed, DPI becomes just as relevant a metric as IRR. This is because DPI represents the actual return on your investment and hasn't been influenced by the time it took the fund to generate the return.

The closest I can come to a final conclusion is the following.

You could argue that for evaluating fund performance, IRR is the most optimal metric. The fund that achieves the highest return in the shortest time will have the highest IRR. However, be vigilant in interpreting the metric in context, such as assessing how effectively the fund has invested its commitment. If, on the other hand, you want to evaluate your investments based on which fund has given your investment the highest multiple – regardless of the time aspect – DPI is the superior metric.

Do you have an accurate overview of the various private equity metrics on your investments?

Through our close to 20 years of experience, we've seen a steep rise in our clients’ allocation to private equity, and the trend is only continuing.

We’re witnessing an increasing need for hassle-free private equity reporting that makes it possible for investors to keep track of their total unfunded commitment and investment results across different funds.

Unfortunately, you can't directly compare the metrics and return percentages from different funds because they calculate and report them differently.

At Aleta, we have a thorough understanding of most private equity funds and their reporting practices, and we have extensive experience in private equity reporting.

By applying the same calculation methods for various private equity metrics across all funds, we enable you to compare fund results effectively.

In that way, you can make well-informed decisions for your private equity investments.

Drop a line if you have any questions about the article or our wealth platform.

At Aleta, we have a thorough understanding of most private equity funds and their reporting practices, and we have extensive experience in private equity reporting.

By applying the same calculation methods for various private equity metrics across all funds, we enable you to compare fund results effectively.