A better way to understand internal rate of return

Investments can have the same internal rate of return for different reasons. A breakdown of this metric in private equity shows why it matters.

Executives, analysts, and investors often rely on internal-rate-of-return (IRR) calculations as one measure of a project’s yield. Private-equity firms and oil and gas companies, among others, commonly use it as a shorthand benchmark to compare the relative attractiveness of diverse investments. Projects with the highest IRRs are considered the most attractive and are given a higher priority.

But not all IRRs are created equal. They’re a complex mix of components that can affect both a project’s value and its comparability to other projects. In addition to the portion of the metric that reflects momentum in the markets or the strength of the economy, other factors—including a project’s strategic positioning, its business performance, and its level of debt and leverage—also contribute to its IRR. As a result, multiple projects can have the same IRRs for very different reasons. Disaggregating what actually propels them can help managers better assess a project’s genuine value in light of its risk as well as its returns—and shape more realistic expectations among investors.

Since the headline performance of private equity, for example, is typically measured by the IRR of different funds, it’s instructive to examine those funds’ performance. What sometimes escapes scrutiny is how much of their performance is due to each of the factors that contribute to IRR above a baseline of what a business would generate without any improvements—including business performance and strategic repositioning but also debt and leveraging. Armed with those insights, investors are better able to compare funds more meaningfully than by merely looking at the bottom line.

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