IRR
Internal Rate of Return. The annualised return on an investment accounting for the timing of cash flows. PE funds target IRRs typically in the high teens to mid-twenties percent for buyouts.
IRR · the mechanism
1 min read
Convert between a money multiple and an IRR in your head, and say when IRR misleads.
Where it comes up. An MD asks whether an extra year of hold is worth it. The multiple barely moves and the IRR falls off a cliff, and only one of those is the argument.
Know what it is
The annualised rate that makes the present value of the cash flows zero. Unlike a money multiple it accounts for timing, which is why a 2.0x in three years and a 2.0x in seven are very different outcomes and only IRR shows it.
Learn the grid rather than the formula
You will be asked for an IRR without a calculator. Memorise the five-year column and interpolate: 1.5x is about 8%, 2.0x about 15%, 2.5x about 20%, 3.0x about 25%. Over three years the same multiples are roughly 14%, 26%, 36% and 44%.
Know how it is gamed
Because IRR is so sensitive to timing, it can be raised without improving the business: an early dividend recapitalisation returns capital sooner, and a subscription credit line delays the capital call so the clock starts later. Neither changes the cash a limited partner ultimately receives, which is why LPs read IRR alongside the multiple and DPI rather than instead of them.
Worked through
The same $500m equity cheque returning $1,200m, at two different hold periods.
- Exit in year 3
- 2.4x → about 34% IRR
- Exit in year 5
- 2.4x → about 19% IRR
- Exit in year 7
- 2.4x → about 13% IRR
Identical money, three very different results. This is the whole reason a sponsor pushes to exit early, and the reason a hold extension needs the business to keep compounding rather than just survive.
Check yourselfA fund reports a 32% IRR and a 1.4x multiple. What should you ask about?
Answer once you have one →
The hold period, and how much of the return came back early. A 1.4x producing a 32% IRR implies money returned in roughly eighteen months, which points at a dividend recapitalisation or a quick flip rather than an operational improvement. Neither is wrong, but the headline IRR flatters a modest multiple, and the multiple is what actually landed in the LP’s account.
Be able to say this back next week
- Converted between a multiple and an IRR without a calculator
- Said IRR accounts for timing and MOIC does not
- Named how IRR is flattered: early distributions and subscription lines
Why IRR matters in interviews
IRR is the number private equity is measured and paid on, so interviewers test whether you understand its mechanics and its weaknesses. The most revealing follow-up is why a fund would take a lower-IRR deal, because it exposes whether you know that IRR is time-sensitive and MoIC is not.
How it works in practice
IRR is the discount rate at which the net present value of all cash flows equals zero — the annualised compound return on invested capital, accounting for when cash comes back.
Because it is time-weighted, an early exit flatters it dramatically. Turning $100m into $200m in two years is a 41% IRR; the same 2.0x over five years is about 15%. This is why sponsors pursue early dividend recapitalisations even when they do not change total proceeds.
Approximation ladder for five-year holds: 1.5x ≈ 8%, 2.0x ≈ 15%, 2.5x ≈ 20%, 3.0x ≈ 25%, 4.0x ≈ 32%. Interviewers expect you to work from these rather than compute.
What candidates get wrong
- Treating IRR and MoIC as interchangeable. A 3.0x over ten years is a mediocre 12% IRR; a 1.6x over eighteen months is an excellent one.
- Forgetting that IRR assumes interim cash flows are reinvested at the IRR itself — an assumption that rarely holds and which MIRR exists to correct.
- Not being able to explain why a fund might prefer a lower-IRR, higher-MoIC deal: absolute dollars of profit, deployment of a large fund, and carry generation all argue for it.
IRR: frequently asked questions
What is the difference between IRR and MoIC?
MoIC is total cash returned divided by cash invested and ignores timing entirely. IRR is the annualised rate that sets net present value to zero and is highly sensitive to timing. A deal can have a strong MoIC and a weak IRR if it takes a long time, or the reverse if capital returns quickly.
What is a good IRR in private equity?
Funds typically target 20-25% gross IRR at the deal level, which nets down after fees and carry. The preferred return threshold above which general partners earn carry is conventionally 8%, so returns below that generate no incentive compensation for the sponsor.
Where IRR comes up
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