Private equity investments have become increasingly popular in recent years. Private equity funding is one of the best options for private businesses looking forward to obtaining capital for expanding and restructuring their businesses. PE investments are a good opportunity for investors to put money into growing privately held companies and earn profits. Investors need to know significant key metrics used in private equity to measure and calculate the potential return like IRR.

IRR is calculated to find the profitability of an investment. It measures the cash-on-cash return in the investment period. Here, we discuss everything you need to know about IRR and how to calculate it.

What is IRR?

Private equity is an investment made in privately held companies. Private equity firms get funding from LPs or limited partners. The investors put their money in privately held companies that have the potential to grow in the future. These funds are returned to the investors in five to seven years, requiring PE firms to exit their investments.

IRR, or Internal Rate of Return, is a key financial metric that measures an investment's profitability. It considers the present value of the cash inflow and outflow in the investment. The things that affect the IRR private equity calculation are the magnitude of the cash flows and timing.

How to Calculate IRR?

IRR calculates an investment's rate of return during the investment period. It is calculated using the expected cash flow for investors. Large cash inflows increase the IRR, and the cash flows received later can cause lesser IRR. IRR is a powerful calculation method employed by several private equity firms today to evaluate the potential of an investment, its expected profitability, and viability.

To calculate IRR for private equity investments, you must take the initial investment amount, cash flows, investment time, etc. The IRR formula is:

NPV = 0 = CF₀ + CF₁/ (1 + IRR) + CF₂/ (1 + IRR) ² + … + CFₙ/ (1 + IRR) ⁿ

In this formula, NPV is the net present value of the investment project. CF₀, CF₁, CF₂, etc., are the cash flows at different investment times.

The formula for calculating IRR determines the discount rate that makes the current cash flow value equal to zero.

Read More: Private Equity Certificate

The Role of IRR Calculation in Private Equity

The private equity investors ensure to use of internal rate of return calculation for various reasons,

Making Investment Comparisons

The IRR allows investors to evaluate and compare different investment opportunities. The PE investors need to assess various possible investments. IRR helps them rank the investment projects according to the expected returns.

Finding Hurdle Rate

The IRR enables the investors to find the minimum acceptable rate of return or hurdle rate. This allows them to maximize the return. The hurdle rate is the lowest IRR for an investment to get and justify the risks. Since the investments and risks are illiquid, PE investors must use this metric to determine the expected return.

Decision-Making Tool

The IRR is a primary tool for making investment decisions. The investors use this instrument to find the cash flow volume during the investment time. Investors can also use IRR to find the viability and profitability of an investment. Using the same, the investors weigh the risks and returns by considering cash inflows and outflows. IRR helps provide investors with a wide view of investment performance, allowing them to make the right choices.

IRR Calculation: The Limitations

While the Internal Rate of Return or IRR enables the investors to determine the profitability of an investment, it also has certain downsides that must be considered.

Too Many Assumptions

Investors must make several assumptions to calculate the IRR. These assumptions are based on projections. When these assumptions change, the calculated IRR will have a huge disparity. This sometimes makes IRR uncertain, and investors may find the tool unreliable for decision-making.

Assumes Reinvestment

IRR assumes that the generated cash flows will be reinvested at the same rate as the IRR. This may not be correct because it is difficult to reinvest cash flows at the same rate. Different investment opportunities with different returns and risks make finding the actual reinvestment rate challenging.

Doesn't Consider Investment Size

Rather than considering value, IRR focuses on the percentage return of the investment. When two projects have different investment sizes and the same IRR, one may still provide better returns in absolute terms. IRR often leads to faulty comparisons and decisions without considering the investment size.

Wrapping up

Investors use many equity valuation methods to find whether the investment will be lucrative or not in the future. The internal rate of return, or IRR calculation, is extremely important for PE investors. They frequently use this calculation to evaluate the profitability of their investments.