Formula
How to Calculate IRR
IRR is the annualized rate that makes the present value of an investment's cash flows equal zero. It is the timing-sensitive companion to a multiple.
Internal Rate of Return
0 = Σ CFt / (1 + IRR)^t
Where
- CFt
- = Cash flow at time t
- IRR
- = Discount rate that makes NPV equal to zero
- t
- = Time period
What Is IRR?
Internal rate of return is the single annualized discount rate at which the present value of an investment's cash flows equals zero, with capital calls entering as negatives, distributions as positives, and remaining net asset value as a final positive on the measurement date. ILPA defines it as the discount rate at which the present value of future cash flows equals the cost of the investment. Cambridge Associates calls it the standard measure of returns for private investments, because dollar-weighting the flows holds a manager accountable for when capital was drawn.
Worked Example
Suppose an investor pays 10,000,000 dollars into a fund at the start and receives a single 25,000,000 dollar distribution five years later. The IRR is 2.5 raised to the power of one fifth, minus 1, or 20.1 percent, on a 2.5x multiple. Now suppose the same 25,000,000 dollars arrives in year eight instead. The multiple is still 2.5x, but the IRR falls to 12.1 percent. Nothing about the underlying investments changed; only the elapsed time did. That sensitivity is why IRR is always shown next to a multiple, and why an IRR quoted without its cash flow dates is not a claim anyone can check. Figures are hypothetical.
Why IRR Matters
IRR moves real money. It determines whether a preferred return has been cleared and therefore when carried interest is paid, and it is the number limited partners rank managers on within a vintage year. It is also the metric most easily flattered, by subscription lines that delay capital calls and by choosing when to realize. Anyone reading a fund's IRR needs to know whether it is gross or net and what cash flow schedule sits behind it.
Related Terms
Frequently Asked Questions
How do you calculate IRR?
IRR is calculated using the formula: 0 = Σ CFt / (1 + IRR)^t. IRR is the annualized rate that makes the present value of an investment's cash flows equal zero. It is the timing-sensitive companion to a multiple.
What is a good IRR?
What constitutes a "good" IRR depends on context — the fund's stage, vintage year, and strategy. Check our benchmarks and calculators for specific ranges.