Private Equity: Episode 3 - IRR

In Episode 2, we mentioned the performance of Private Equity by presenting its IRR (Internal Rate of Return) over the last 15 years. But how is the IRR of an investment actually calculated?

The Internal Rate of Return is a widely used tool to measure the profitability of an investment over a given period.

In the simplest cases, there are only three key variables to consider:

• Initial Investment Amount
• Exit Amount
• Holding Period

The formula for IRR is:
IRR = (Exit Amount / Initial Investment) ^ (1 / Holding Period) – 1

Example:

You invest €10,000, and three years later, you exit at €35,000.

• Initial Investment Amount: €10,000
• Exit Amount: €35,000
• Holding Period: 3 years

IRR = (35,000 / 10,000) ^ (1 / 3) – 1
IRR = 52%!

This straightforward calculation focuses on a single investment with an entry and an exit.

Calculating IRR is far more insightful than using the Cash-on-Cash multiple (a simple exit multiple, 3.5x in this case), as it factors in the investment’s holding period.

A Private Equity fund’s IRR makes it possible to compare its performance to other investments.

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