Understanding Internal Rate Of Return in Private Equity?

The IRR takes into account the time value of money and is dependent on a fund’s cash inflows and out- flows. It is a reconstructed (and theoretical) annu-
alised rate of return. Given a certain investment amount, with all other things equal, the shorter the holding period of the investment, the higher the IRR.

Internal Rate of Return (IRR) represents the annualised implied discount rate calculated from a series of cash flows.
The IRR-method is the typical performance method for private equity funds because portfolio investments are
bought and sold over time with several capital contributions and distributions. The IRR-method cannot be compared
to interest rates of typical bank account interest rate calculations. The IRR-method considers only the tied up cash
and only over the period of time during which the cash is tied up. The IRR-method typically indicates therefore a
higher return than the use of another calculation methodology. Investors should therefore not use IRR-numbers as a
return measure in comparison to other investments. Furthermore, it is important to scrutinize the assumptions for
the calculations when comparing returns of various investments.