What Is the Internal Rate of Return (IRR)?
The internal rate of return is the discount rate at which the present value of an investment's cash inflows exactly equals its cost, making NPV zero. Intuitively, it is the compound annual growth rate your money earns while invested, accounting for exactly when cash goes out and comes back.
The decision rule is to accept investments whose IRR exceeds the required return or hurdle rate. In private equity, IRR is the language of the industry: fund performance, deal returns, and carried interest hurdles are all expressed in IRR terms.
How It Works
IRR solves for r in the equation 0 = -Initial Investment + sum of CFt / (1 + r)^t, which generally requires iteration or a spreadsheet function rather than algebra. Because it is time-weighted, IRR rewards getting capital back quickly, which is why PE firms use dividend recapitalizations and early exits to boost it.
IRR has quirks: projects with alternating positive and negative cash flows can have multiple IRRs, and a high IRR on a small, short deal can create less actual wealth than a lower IRR on a large, long one. For this reason investors pair IRR with the multiple on invested capital (MOIC).
Example
A private equity firm invests $100 million of equity in a buyout and receives $250 million when it sells the company five years later, with no interim cash flows. The IRR solves $100 x (1 + r)^5 = $250, so r = (2.5)^(1/5) - 1 = 20.1%. That is a 2.5x multiple of money at roughly a 20% IRR; if the same exit happened in year three instead, the IRR would jump to about 35.7%, showing how powerfully timing drives the metric.
Why It Matters
IRR is the primary yardstick for private equity, venture capital, and real estate investing, determining whether general partners earn carried interest above their hurdle rate. It also lets investors compare opportunities with very different sizes and timelines on a common annualized basis.
A favorite interview prompt is estimating IRR mentally from a multiple and holding period, so it helps to memorize that doubling your money in five years is roughly a 15% IRR and tripling it is about 25%.
