What is IRR and why is IRR the most important metric for Venture Capitalists
The Internal Rate of Return (IRR) is an important metric used to evaluate and compare investments.
What is IRR?
Here is a definition of IRR:
The Internal Rate of Return (IRR) is the annualized discount rate at which the net present value of all cash flows from an investment equal zero. In other words, it is the expected compound annual rate of return that an investment provides.
To break this down:
- IRR calculates the annual growth rate you can expect to receive from making a certain investment.
- It equates the present value of future cash inflows with the initial investment made today. That “equating” occurs when the investments net present value equals zero.
- A high IRR indicates a more desirable investment, because it means your annual return is higher per dollar invested.
Some key things about IRR:
- It allows investors to compare returns across different investment sizes or durations by standardizing to an annual return rate.
- Unlike some returns metrics, it accounts for both the investment amount AND the timing/size of future cash flows.
- A project is considered an appropriate investment if its IRR exceeds a hurdle rate or minimum return threshold.
How to Calculate the IRR?
Let’s calculate IRR with an example.
A $100 million venture capital fund returns 3X or $300 million to investors after 8 years. What is the IRR?
Let me show the step-by-step math for calculating the IRR in this case:
- Initial Investment = $100 million
- Cash Inflow = $300 million (after 8 years)
- IRR is the discount rate that makes the net present value of the cash flows equal to zero.
- So we need to calculate the discount rate where:
Initial Investment Value + Sum of Discounted Cash Flows = 0
- Mathematically this is: -$100 million + $300 million / (1 + IRR)^8 = 0
- Rearrange to solve for IRR: $300 million / (1 + IRR)^8 – $100 million = 0 (1 + IRR)^8 = $300 million / $100 million
(1 + IRR) = (3)^(1/8) IRR = (3)^(1/8) – 1 - Plugging this into a calculator: IRR = 20%
So the mathematical steps to calculate the IRR are to 1) Set up the NPV equation equaling zero, 2) Rearrange to isolate IRR, and 3) Solve for IRR.
Why IRR is Important and Used by VCs to Measure Success?
IRR is an important metric used by venture capitalists to measure the success of their investments for a few key reasons:
- High Potentials Returns: Venture capital investments are high risk, but have the potential for very high returns. IRR allows VCs to quantify what annualized return rate an investment could achieve if successful. This indicates the home-run potentials.
- Portfolio Performance Benchmarking: Venture funds measure their overall fund performance using the IRR across their portfolio. It allows benchmarking performance to other VC firms of different fund sizes and investment durations.
- Factor in Investment Duration: Unlike some return metrics, IRR factors in the duration of the investment and the timing of cash inflows back to the investors. This accurately represents the actual annual yields.
- Guide Portfolio and Exit Decisions: By comparing IRR projections of investments needing additional funding versus potential exits, VCs can evaluate the attractiveness of selling or holding investments.
- Attract Limited Partners (LPs): Reporting high realized IRRs on previous funds helps VCs raise funding from LPs for new investment vehicles. This enables new deals.
IRR helps quantify the extremely high return expectations in the risky world of venture investing. As a standard annualized return metric, it enables better decision-making by both venture capital funds and their investors.
Who are LPs or Limited Partners?
LPs, or Limited Partners, refer to the investors in a venture capital fund. Some key points on who LPs are and why IRR is an important metric for them:
Who are LPs?
- Institutional investors like pension funds, endowments, foundations
- Wealthy individuals/family offices
- Fund of funds
- Sovereign wealth entities
LPs commit large sums of money to venture capital funds as their “limited partners”, providing the investment capital used by VCs.
Why IRR is important to LPs:
- LPs want high return potential from risky VC investments. IRR shows home-run return rates.
- LPs allocate to multiple VC funds for diversification. IRR enables comparison across their different VC fund investments.
- Historical realized IRRs indicate VC fund teams that successfully generated returns in the past.
- IRR factors in the long-term orientation of VC investments, rather than short term horizons.
In essence, LP investors use IRRs to evaluate VC fund performance, conduct due diligence on prospective fund managers to invest in, and determine the pacing of capital calls to smoothen returns.
So while VCs use IRRs to make their investment decisions, Limited Partner investors use it to make fund investment decisions. Tracking this return metric alignment is key.
