Internal Rate of Return (IRR)

IRR answers the question: 'What annual return does this investment generate?' Mathematically, you solve for the rate r where: 0 = -Initial Investment + CF₁/(1+r) + CF₂/(1+r)² + ... There is no closed-form solution — it must be solved iteratively (or with Excel's IRR function). A higher IRR means a more attractive return. In PE, a 'good' IRR is typically 20%+ net to investors, though top-quartile funds consistently achieve 25%+ gross IRR.

PE firms target gross IRRs of 20–30%+ on individual deals. IRR is highly sensitive to timing — returning capital quickly boosts IRR even if total cash returned is smaller. A fund that doubles money in 3 years earns ~26% IRR, but doubling in 5 years earns only ~15% IRR. This timing sensitivity is why PE firms use dividend recapitalizations (borrowing against the company to pay a special dividend) to return capital early and boost IRR. The trade-off: MOIC (Multiple on Invested Capital) may be lower.

IRR assumes intermediate cash flows are reinvested at the IRR itself — often unrealistic if the IRR is 30%+. Non-conventional cash flows (alternating positive/negative) can produce multiple IRRs, making interpretation impossible. IRR also doesn't measure absolute value creation — a $1M project with 50% IRR creates less value than a $100M project with 20% IRR. MIRR (Modified IRR) addresses the reinvestment assumption by using a more realistic reinvestment rate.

MOIC = Total Cash Returned / Total Cash Invested. It measures total value creation without considering timing. A deal returning 3.0x MOIC over 10 years has a lower IRR (~12%) than a 2.0x MOIC in 3 years (~26%). PE professionals evaluate both metrics together (see IRR vs. MOIC): high IRR + high MOIC is ideal, high IRR + low MOIC suggests quick but small returns, and low IRR + high MOIC suggests value creation over a long hold period.