To IRR is human, to forgo divine. Simple measurements have a great allure as they are seemingly clear, easy to rank and require little explanation. IRR, or internal rate of return, has been the prevailing measure of performance in private equity for decades as it seems to resemble ROE and ROI, but actually has very different mathematics. In IRR, one of the key assumptions is that the cash distributed during the life of an investment will be reinvested at the same rate of return as the investment. In other words, the assumption is that $1 MM distributed in year two of a five year 20% project will be immediately reinvested at a 20% rate. Real experience suggests that is both unlikely and impractical. Normally when an investor receives a distribution, it is invested in the equivalent of a money market fund. From 2021 through today, those funds earned between 20 basis points (.20%) to 400 basis points (4.0%). One could also assume the cash is reinvested at the long-term average return of the investor, say 7%. If one adjusts a stream of cash flows to reflect reinvestment rate similar to the above alternatives the net IRR starkly changes. We took a ten-year stream of cash flows that generated a 17.6% IRR and modified them using reinvestment rates of 2%, 4% and 7%. See table below:
Modified IRR
Traditional IRR 17.6%
Reinvest @ 7% 11.6%
Reinvest @ 4% 9.9%
Reinvest @ 2% 8.7%
The dampening effect seen above illustrates why IRR is both an interesting data point and in need of accompanying analytics. Setting aside the insufflation of IRR caused by a credit line still leaves questions. When reviewing Funds on the Endowment Investment Committees where I sit, we look at IRR, but very quickly turn to DPI and to net MOIC to assess the manager’s ability to grow the value of a Fund’s assets. As one of my first pension managers told me “You cannot pay pension checks with IRR, you need cash”. A weighted balance of IRR, cash generated, and potential cash is likely the best way to measure these investments despite the appeal of a simple measure. This same logic applies to evaluating capital projects at our portfolio companies. Often, we pair a simple cash payback analysis with the above to help evaluate a capital project. Letting IRR act as a shark cage when evaluating investments is simple, but not likely to be robust. The liquidity trap many found themselves entering in late 2021 – 2022 was driven by pursuing IRR to the detriment of cash returns. Similar to the Rommel troops in Egypt, one has to make sure to not outrun the lifeblood that is the supply line, or in this case, cash.
I’m Rob Morris and I approved this blog.