🟢 ROI shows my return in DOLLARS

🟢 IRR shows my ROI adjusted for TIME


You need both to understand the return of an investment.


I’ll explain...


🟢 Let's start with the easier one — ROI.


ROI means "Return on Investment"

(↑ btw, this is often called MOIC or "Cash-on-Cash")

▪️ If I invest $100 and get back $200 my ROI is 2.0x = ($200 / $100)

▪️ If I invest $100 and get back $300 my ROI is 3.0x = ($300 / $100)

Make sense?


But now let's introduce TIME...


If I make 2.0x in one month, great!


But if I make 2.0x in 100 years... not so great.


So I need a way to measure my ROI over TIME as well.


🟢 That's where IRR comes in.


IRR means "Internal Rate of Return,"


and while IRR is often used alongside NPV & DCF analysis,


I want to simplify it further...


Let's say IRR means the "annualized rate of return for an investment."


In other words, "what percent did I make PER YEAR?"


10%? 25%?


Let's go back to the examples above...

▪️ 2.0x in one month: 409,500.0% (← ...uh what?)

▪️ 2.0x in 100 years: 0.7% (← makes more sense)


This is where IRR can be misleading and why it's common for private equity folks to say "you can't spend IRR."


IRR calculates an ANNUALIZED percent return, so big returns in the early days can skew the numbers.


If I crush it in the first month, my IRR formula says, "whoa! you're gonna keep this up all year — nice!"


But in reality it won't play out that way.


The IRR starts to feel more "palatable" as time goes by, for example:

▪️ 2.0x after 6 months: 300%

▪️ 2.0x after 1 yr: 100%

(↑ I doubled up in one year, and IRR is an annualized number, so it's 100%)

▪️ 2.0x after 2 yrs: 73%

▪️ 2.0x after 3 yrs: 44%

▪️ 2.0x after 4 yrs: 32%

(↑ see how it drops off steeply & then smooths out?)


🟢 And this is why you need BOTH.


Without the other, they can both be misleading.


So you compare them side-by-side:


As of [date] my ROI was [X] and my IRR was [Y].

———

Note, this gets trickier once you factor in timing of cash flows...


If I invest $100, get $120 back in month 2 and $80 back in month 6,


I've still made 2.0x, but my IRR will be much higher than 300%.


(↑ conversation for another time).

———

So how do I think about it in my head?


I just compare any private investment to the stock market.


If I can open a brokerage account, pay basically no fees, take my money out anytime, and make 7-10% on average...


Then locking up my capital in an illiquid private investment (that has fees) must have a MUCH higher IRR than 7-10%.


That premium needs to compensate me for the additional risk I'm taking.


Which leads me to a common private equity metric...


Most deals target 3.0x over 5 years at a ~25% IRR.


This is the goal post set in most models.


(↑ much higher than the market to compensate for the risk)

—Chris

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