The internal rate of return (IRR) is a commonly used metric to estimate the profitability of an investment. It can be used to assess whether an investment is worth making or not. It is also used to assess the performance of investment funds, such as venture capital and private equity funds.
However, an IRR can be somewhat misleading and actual returns can differ significantly from what the IRR shows you. This is because the IRR only calculates the return on investment starting at the point when cash is deployed. In many funds, cash may not be deployed immediately, which results in a cash drag that is not accounted for in the IRR calculation.
The IRR also makes an assumption that the cash generated can be redeployed at the calculated IRR rate. This is often not the case.
Here are some examples to illustrate these points.
Cash drag
Venture capital and private equity funds are unique in that investors do not give the committed capital to a fund immediately. Instead, investors make a commitment to a fund. The fund only asks for the money when it has found a startup or company to invest in; this is called paid-in capital, which differs from committed capital.
To calculate returns, venture capital and private equity funds use the IRR based only on paid-in capital. This means that while the IRR of two venture funds can look the same, the actual returns can be very different. Let’s look at two IRR scenarios below:
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | IRR | |
| Fund A | -$1000 | 0 | 0 | $2000 | 0 | 0 | 26% |
| Fund B | 0 | 0 | -$1000 | 0 | 0 | $2000 | 26% |
Both Fund A and Fund B have an IRR of 26%. The difference is that Fund A deployed the capital straight away while Fund B only found an investment in Year 3. Investors in Fund A are actually much better off as they can then deploy the $2000 received in Year 3 into another investment vehicle to compound returns. Fund B’s investors, meanwhile, had a cash drag with committed capital that was not deployed in Year 1 and 2, and this drag is not recorded in the IRR calculation.
Wrong assumptions
The IRR formula also assumes that the cash returned to investors can be redeployed at the IRR rate. As mentioned above, this is not always the case. Take the example below:
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | IRR | |
| Investment A | -$1000 | $300 | $300 | $300 | $300 | $300 | 15.2% |
| Investment B | -$1000 | 0 | 0 | 0 | 0 | $2025 | 15.2% |
In the above scenario, both Investment A and Investment B provide a 15.2% IRR. However, there is a difference in the timing of cash flows. Investment A provides cash flow of $300 per year while Investment B provides a one-time $2025 cash flow at the end of Year 5. While the IRR is the same, investors should opt for Investment B.
This is because the IRR calculation assumes that the cash flow generated can be deployed at similar rates as the IRR. But the reality is that oftentimes, the cash flow can neither be redeployed immediately, nor at similar rates to the investment.
For instance, suppose the cash flow generated can only provide a 10% return. Here are the adjusted returns at the end of Year 5 for Investment A
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | IRR | |
| Investment A | -$1000 | $300 | $300 | $300 | $300 | $300 | 15.2% |
| Investment A (adjusted) | -$1000 | 0 | 0 | 0 | 0 | $1832 | 12.9% |
| Investment B | -$1000 | 0 | 0 | 0 | 0 | $2025 | 15.2% |
I calculated $1832 by summing up the cash flows with the extra returns generated by investing the cash flows at a 10% rate. As you can see, after doing this, the returns generated from investment A now fall to just 12.9% vs the 15.2% previously calculated.
The bottom line
Using the IRR to calculate investment returns is a good starting point to assess an investment opportunity. This can be used for investments such as real estate or private equity funds.
But it is important to note the limitations of the IRR calculation. It can overstate or understate actual returns, depending on the timing of the cash flows as well as the actual returns on the cash generated.
A key rule of thumb is that the IRR is best used when cash can be deployed quickly so that there is minimal cash drag, and when the cash generated can be deployed at close to the IRR of the investment. If this assumption does not hold true, then a manual calculation of the returns of the investment need to be made by inputting the actual returns of the cash generated.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any companies mentioned. Holdings are subject to change at any time.