Performance Metrics
Internal Rate of Return
IRR
The annualized rate of return that makes the net present value of all cash flows equal to zero.
Internal Rate of Return (IRR) is the most commonly used performance metric in private equity. It represents the discount rate at which the net present value (NPV) of all cash flows (both contributions and distributions) equals zero.
IRR accounts for the time value of money, making it particularly useful for investments with irregular cash flows like PE funds. However, it can be influenced by timing of capital calls and distributions, and assumes reinvestment at the same rate.
Key characteristics
- Time-weighted: Earlier returns have more impact than later ones
- Annualized: Expressed as a percentage per year
- Net vs Gross: Net IRR is after fees, Gross IRR is before fees
Limitations
- Can be manipulated through early distributions
- Difficult to compare across different fund lives
- Assumes reinvestment at the IRR rate
Formula
0 = Σ [Cash Flow_t / (1 + IRR)^t]Example
A fund that calls $100M in year 1 and distributes $200M in year 5 has an IRR of approximately 15%.