Internal rate of return is the annualized discount rate at which the present value of an investment’s cash flows nets to zero — and because it is annualized, a fund can post a spectacular IRR on a deal that returned less absolute money than a slower one, simply by returning it faster.
The Institutional Limited Partners Association — the body whose reporting templates Canadian GPs and LPs work from as much as anyone else’s, and which keeps a Toronto office — defines it as “the discount rate at which the present value of future cash flows of an investment equals to the cost of the investment.” The mechanical consequence of that definition is time sensitivity: IRR is expressed per year, so the same multiple of money returned produces a dramatically different IRR depending on how long the capital was outstanding, which is exactly why IRR and a fund’s DPI or multiple-on-invested-capital can tell an LP two different stories about the same deal.
This is not a quirk to work around, it is the whole reason LPs are trained to read IRR alongside a multiple rather than on its own. A fund manager choosing between exiting a strong asset early at a good multiple, versus holding for a larger eventual multiple, is making a real trade-off between an IRR-maximizing path and a total-value-maximizing one — and a track record built disproportionately on quick flips can show an outstanding headline IRR while having returned less absolute capital to LPs than a slower, patient one would have.
Two exits, computed on the same simple single-cash-flow-in, single-cash-flow-out basis (multiple to the power of one over the number of years, minus one). Deal A is held one year and returns 1.3× the capital invested: IRR = 1.31/1 − 1 = 30%. Deal B is held five years and returns 2.5× the capital invested — nearly double Deal A’s multiple: IRR = 2.51/5 − 1 ≈ 20%. Deal B returned LPs far more actual money per dollar invested, but Deal A posts the higher IRR, purely because it returned its (smaller) gain in a fifth of the time. A track record built by quoting IRR alone would rank Deal A the better outcome; a track record read on DPI and multiple would say the opposite — and an LP evaluating a fund’s history needs both numbers, not the one that flatters the manager’s pattern of exits.
See also: Distributions to paid-in capital · Carried interest · Preferred return.
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