IRR, or internal rate of return, is a useful measure when trying to understand the performance of an investment with multiple payouts over a period of time. It is a means of incorporating the time value of money into the evaluation of an investment. IRR tells us the average annual discount rate at which cash flows, both positive and negative, equal zero.

Q. So, we all know this relates to the computation of investment returns. Let’s forget the detailed math of it, but what’s the key idea for investors?

A. The big point is that it’s a much better way of calculating investment performance than the obvious one. Consider a real estate deal. If you just take the final sale proceeds of the investment, minus expenses along the way, to get a total profit; and divide that by the profit by the total amount invested, we have a total percentage return: I made 30% on my money!

But its not a great way to analyze the investment. We need to consider time to determine the “real” rate of return generated. So IRR accounts for when you made the initial investment, when you made capital improvements, etc.. it takes account of the lumpy investments, adjusts for how long how many dollars are invested, and generates a percentage rate of return you’re actually making while the dollars are in the project.

Q. So, IRR is important to make sure we’re talking apples to apples with potential investments.

A. Exactly, really critical for that. But another way of expressing the concept, a little more common for investments in securities, is: what is the compound annual growth rate, the CAGR? You take the bookends: how much was invested on day one, how much came back on day X, and then figure out what compounded annual interest rate is necessary to get you from X to Y. You can compare that to an IRR.

Q. PE and VC firms often use IRR to describe their performance. What are the limitations of using IRR to evaluate an investment in fund?

A. There are really two big ones. The first is that when funds brag about the IRR they achieved, the investor has to recognize that he might not actually get that number himself on the dollars he commits to the fund. First, to maximize its IRR, the fund won’t take in all the investors’ dollars at one time, but rather only over time, as the need is there. So the investor has to keep his dollars liquid for the capital call, but won’t be earning that IRR rate meantime. Same thing on the other end… once a fund liquidates its investment in something, those dollars come back out to the individual. Unless he can reinvest at the same IRR the fund is realizing, his returns on the committed will be lower than the stated fund IRR over the life of the fund.

Q. Ha, interesting. But still, the investor is getting the advertised rate while the dollars are actually in the fund. So, what’s the second issue?

A. IRR tells you nothing about the amount of risk you are taking to get the return, obviously a critical issue. To understand more about that, we’ll need to discuss standard deviation, so we’ll do that one soon.