12.2 Internal Rate of Return (IRR) and Multiple on Invested Capital (MOIC)

Private equity firms use Internal Rate of Return (IRR) and Multiple on Invested Capital (MOIC) to measure investment performance. These metrics help investors understand returns over time and total profit, providing crucial insights into fund success.

IRR calculates annualized returns, while MOIC shows total return as a multiple of initial investment. Both have strengths and limitations. Using them together gives a fuller picture of investment performance in private equity portfolios.

Return Metrics

Key Performance Indicators in Private Equity

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  Time-weighted Return vs. Money-weighted Return – Brightwood Ventures LLC View original

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  Time-weighted Return vs. Money-weighted Return – Brightwood Ventures LLC View original

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• Internal Rate of Return (IRR) measures the annualized return on investment over its lifetime
• Multiple on Invested Capital (MOIC) calculates the total return on investment as a multiple of the initial capital
• Time-Weighted Return (TWR) evaluates investment performance independent of the timing of cash flows
• Money-Weighted Return (MWR) accounts for the size and timing of cash flows in performance measurement

Advanced Return Concepts

• IRR considers the time value of money and provides a percentage return
• MOIC offers a simple measure of total return without accounting for the time value of money
• TWR eliminates the impact of external cash flows on performance measurement
• MWR incorporates the impact of cash flow timing and size on overall returns

IRR and MOIC Details

Understanding IRR and Its Limitations

• IRR calculates the discount rate that makes the net present value of all cash flows equal to zero
• Realized returns represent actual cash returns from exited investments
• Unrealized returns include paper gains or losses on investments still held in the portfolio
• IRR assumes reinvestment of interim cash flows at the same rate, which may not be realistic
• IRR can be manipulated by changing the timing of cash flows (early distributions)
• Multiple IRRs can occur in investments with non-conventional cash flows (positive and negative flows alternating)

MOIC Calculation and Applications

• MOIC computed by dividing the total value returned to investors by the total amount invested
• MOIC formula: $(Total Value to [Paid-In Capital](https://www.fiveableKeyTerm:Paid-in_Capital)) / (Paid-In Capital)$
• Total value includes both realized proceeds and unrealized value of remaining investments
• MOIC provides a straightforward measure of investment return without time value considerations
• Useful for comparing investments with different durations or cash flow patterns
• MOIC complements IRR by offering a different perspective on investment performance

Comparative Analysis of Return Metrics

• IRR and MOIC often used together to provide a comprehensive view of investment performance
• TWR useful for comparing fund manager performance across different time periods
• MWR more appropriate for individual investors to assess personal portfolio performance
• Realized returns offer concrete evidence of investment success
• Unrealized returns require careful valuation and may be subject to change before exit