Internal Rate of Return (IRR)

The Internal Rate of Return, or IRR, is a return metric that also takes the timing of payments into account. It indicates the annual return at which an investment pays off over time. Especially for funds, it is a central measure of success. Mathematically it is the discount rate at which the net present value of all inflows and outflows is exactly zero. It is generally computed iteratively, because the equation cannot be solved directly for more complex cash flow patterns.

Accounting for payment timing is both its strength and its weakness: it reflects that early distributions are worth more than late ones, but makes the metric sensitive to payment timing. Doubling an investment in three years equates to roughly 26 percent per year, the same doubling over six years to only about 12 percent, even though the same amount was earned in both cases. It follows that the metric can be managed: subscription facilities at fund level that delay capital calls, and distributions pulled forward through a dividend recapitalisation, improve the reported figure without creating more value. It is therefore always considered alongside the multiple on invested capital, which measures absolute return and cannot be improved in that way. Further weaknesses are the implicit assumption of reinvestment at the same rate and the possibility of multiple solutions where the cash flow series changes sign.

In practice the internal rate of return nevertheless remains the usual target measure against which investment decisions are judged. It should be noted that the metric reads differently for individual investments and for whole funds: at investment level it measures the success of a specific decision, at fund level it additionally reflects the ability to call and return capital at the right time. Whether the figure is stated before or after fees and carried interest matters equally, because the difference over a fund's life amounts to several percentage points.