Internal rate of return (IRR)

The IRR is one of the key metrics used to evaluate investment performance. A higher IRR indicates a more profitable fund. VC firms often use IRR to compare the attractiveness of different investment opportunities and to assess the performance of their portfolios. Indeed, by helping limited partners benchmark a fund’s performance against its peers, the IRR helps them make better investment decisions. It is also a useful tool to compare funds of different vintage years against each other.

Mathematically, the IRR is calculated using the same formula used to calculate the net present value (NPV). To find the IRR, one starts with the equation below, solving for the rate (r) that will set the NPV to zero:

In this formula, C_t represents the cash flows at time t, and r is the internal rate of return. In practice, calculating the IRR can be highly complex, because it involves handling multiple cash flows. As a result, calculations will often be performed using financial software or spreadsheets.

Although useful and widely used, the IRR does have limitations. The first one is its potential for multiple solutions: when an investment has alternating positive and negative cash flows, there can be more than one rate that makes the NPV equal to zero. This multiplicity of results can create difficulties in investment analysis.

Second, the IRR can also be misleading if used in isolation, because it does not account for the scale of the investment or the absolute dollar returns. Finally, the IRR calculation assumes that cash flows are reinvested at the same rate as the IRR, but this is sometimes unrealistic.