IRR (Internal Rate of Return) | Futureproof
IRR (Internal Rate of Return)
Quick Definition
The annualized return rate that makes the net present value of all cash flows equal zero.
What is IRR?
IRR is the annualized rate of return that makes the net present value of all cash flows (both in and out) equal zero. It accounts for the timing of every dollar invested and every dollar returned. A 3x return in 3 years is very different from a 3x return in 10 years. IRR captures that difference.
Why IRR Matters
Multiples tell you how much. IRR tells you how fast. LPs use IRR to compare fund performance across different vintages, strategies, and asset classes. A fund returning 2.5x in 4 years is far more impressive than 2.5x in 12 years. IRR makes that obvious.
Why Timing Changes Everything
Two funds both return 3x. Fund A does it in 5 years (IRR ~25%). Fund B takes 10 years (IRR ~12%). Fund A's LPs can reinvest those returns sooner. Compounding favors speed.
Early distributions boost IRR significantly. This is why some GPs prioritize quick exits on smaller wins to pump fund-level IRR.
Formula
IRR is the rate (r) that solves:
0 = CF₀ + CF₁/(1+r)¹ + CF₂/(1+r)² + ... + CFₙ/(1+r)ⁿ
Where CF = cash flow at each period. No closed-form solution exists. It's solved iteratively (Excel, Python, or your fund admin handles this).
Example
Fund timeline:
- Year 0: LP invests $10M (cash flow: -$10M)
- Year 2: Distribution of $3M
- Year 4: Distribution of $5M
- Year 6: Distribution of $15M
Total multiple: $23M / $10M = 2.3x
IRR: ~18.5% annualized
Same 2.3x multiple compressed into 4 years would yield an IRR north of 25%. The speed of returns is what separates good from great.