With private equity, investors look at the internal rate of return, or IRR, to help gauge their potential earnings. According to Investopedia.com, the IRR is defined as “…a metric used in capital budgeting to estimate the profitability of potential investments”.
While using the internal rate of return can be useful, if utilized incorrectly or without the proper context, this data point can be misleading. A simple example would be looking at three different investments with three different IRR’s. You may think that the best investment has a high IRR compared to the others, but without knowing your required rate of return, or RRR, you may be making a misjudgment.
For instance, if you invested $10,000 in year 1, and then received $5000 in the consecutive year 2, 3, and 4 – your IRR would be 23.3% over the three years. The investment’s gain was 50%. On an annualized basis, this investment would need to generate 14.4%. So if you invested $10,000 that gained 14.4% annually, the investment would then be worth $15,000 in three years, providing you a total 50% return on invested equity. This is not the same as if you invested $10,000 that gained 23.3% (our calculated IRR). This would result in a much higher final gain than indicated by the initial prompt.
As you can see, IRR need not be confused with annualized return rate. Furthermore, IRR alone will not help in creating wealth. If you considering an investment into private equity, make sure to determine how much wealth was created by looking at other metrics as well – not just whether a high IRR was reached.
The positives of IRR, however, are that getting cashflow earlier can be better in the fact that this reduces risk (versus cashflows that happen far out into the future). Thus a higher IRR, will help ascertain this risk.
But at the end of the day, remember IRR and annualized returns are different – albeit many investors equate them to the same thing. When looking at a private equity investment, be sure to consider all metrics including IRR and annualized returns. Ensure that the private equity firm is helping you obtain real wealth.