Musings on Entrepreneurship and Innovation
Monday, August 30, 2004
How the Problem with IRR Can be the Entrepreneur's Problem
It's no secret that internal rate of return (IRR) is a flawed measure of relative financial performance. Nevertheless, as John Kelleher and Justin MacCormack of McKinsey & Company found in an informal survey, only 6 out of 30 executives at corporations, hedge funds, and venture capital firms were fully aware of IRR's most critical deficiency :
IRR is a true indication of a project's annual return on investment only when the project generates no interim cash flows - or when those interim cash flows really can be invested at the actual IRR.
Although many institutional limited partners long ago figured out the sometimes arcane mathematics of IRR calculations, portfolio IRR remains the popular indicator of venture capital performance. But, consider the following hypothetical returns from two $10 million VC funds:
VC 1 invests $10 million and distributes $25 million at the end of year 3 and $26 million at the end of year 10. The IRR on the fund is 40%. VC 2, on the other hand, invests $10 million and collects $289 million at the end of year 10 for an identical IRR of 40%. However, the performance of the first fund is truly equivalent to the performance of the second fund only if the cash distributed at the end of year 3 can be reinvested at a 40% annual rate of return.
Consider, on the other hand, the case where the reinvestment rate is, say, 15%:
The adjusted rate of return is 25%. Not bad, but not eye-popping either.
So what? Well consider the case of a smallish first fund in a hot VC market. Posting a compellingly high IRR could accelerate the GPs' chances of raising a second (much larger) fund. Larger funds have historically meant larger management fees and larger carried interests (in absolute terms). On the one hand, quick returns can boost the apparent IRR of a fund, as illustrated above. On the other hand, quick exits aren't necessarily in the best interest of portfolio companies or limited partners. It just goes to show why an entrepreneur seeking to raise venture capital needs to be aware of the incentives that shape his or her investors' behavior.
Kelleher, John C. and Justin J. MacCormack, Internal rate of return: A cautionary tale. McKinsey on Finance, Summer 2004, pp. 16-19.