IRR (Internal Rate of Return)
The Internal Rate of Return (IRR) is a metric used to evaluate the profitability of an investment, expressed as a percentage. In venture capital (VC), IRR is crucial for evaluating the performance of a fund or specific investment over time. A higher IRR indicates a more profitable investment, but it should be considered alongside other metrics for a comprehensive view.
Pros:
- IRR provides a single number that can be quickly used to compare different investments.
- Encourages time-sensitive behavior, as a high IRR usually indicates quick returns.
Cons:
- It assumes that cash inflows are reinvested at the project's IRR, which might not be realistic.
- It can be manipulated by the timing of cash flows, so it's not always an entirely objective measure.
Some VC or PE firms have been known to focus too heavily on IRR, doing financial engineering to improve it artificially: for instance, by opening lines of credit to do some first investments and only calling LP’s contributions later. This measure lowers a bit the multiple of the investment (as some of the contributions pay back interests), but increases IRR.
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