# Why your Homegrown IRR Math is Probably Way Off and Causing you Problems you Don't Even Realize

Updated: Apr 2, 2020

**Even some experienced investors don't realize that IRR (internal rate of return) and annual return aren't the same thing. So when they create homegrown calculations with IRR, they nearly always come to very inaccurate conclusions. This simple-to-make mistake can lead an investor to take on more risk than they realize, or unnecessarily pass on a deal that was actually attractive to them.**

*(Usual disclaimer: I'm just an investor expressing my personal opinion and not a **registered **financial advisor, attorney or accountant. Consult your own financial professionals before making any financial decisions. Code of Ethics: We do not accept any money from any sponsor or platform for anything, including postings, reviews, referring investors, affiliate leads or advertising. Nor do we negotiate special terms for ourselves in the club above what we negotiate for the benefit of members.).*

## Background: What is IRR?

As investors, we all look at investments differently because of our **unique financial situations** and** risk tolerances**. But every investor cares about **one thing**: **how much money** the deal will **put in their pocket** at the end.

So, almost every sponsor helps investors look at this by providing the **IRR** (**"internal rate of return"**) of the deal. For **example**: "After five years, this deal projects a **10% IRR**". IRR has become an **industry standard** and you'll see it in **virtually every alternative investing deal** (including real estate, private equity, venture capital, litigation finance, life supplements, royalties etc.). And the idea is that you can** use IRR** to **compare deals**. A **5% IRR** deal projects a **lower return** than a **10% IRR** deal. Simple, right?

But this ubiquitous and **simple-sounding metric** is actually very **misunderstood**. And that can cause some** dangerous confusion**.

## "You say tomato, I say tomat-oh"

The **problem** is that "**internal rate of return**" **sounds a lot** **like **"**annual return**". So most investors think they're the **same**. If they hear an investment has a **10% IRR**, they believe that's** the same as** a **10% annual return**.

Occasionally, **they can be right** (which we'll talk about in a minute). But in the world of alternative investing, they're **almost always not**. And when that happens it can be **dangerous**.

Here's the** important difference** between the two.

## "The Incredible Lightness of the Annual Return"

Most of us learned in grade school what an **annual return** is. If you **invest $100 **in a CD and **get back $5 more** at the end of the **year**, you've made a **5% annual return**. It's so simple that a child can both understand and calculate it.

Now, here's the __ definition of IRR from investorpedia__:

"The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same formula as NPV does."

After reading that, you might be saying: "**Huh? **What the heck does that even mean?"

And** that's the point **I'm trying to make. **IRR is super complicated** and very **different **than annual return (and CAGR, APR, % return and all of the other numerous things people usually confuse it with). That's because it incorporates a **much more abstract concept **called the **time value of money (NPV)**.

This is a **fiendishly difficult** thing to **calculate**. It so hard, it can't even be calculated with what we typically think of as a "normal" formula and has to be done through something called** recursion** (which is a process where **a formula is repeated over and over **again and after many many **trials and errors** eventually **narrows in** on the **final answer**). This is so **complex **that, **before** **spreadsheets** were invented, IRR was **very rarely even used**.

Let's take a look at **this** **nasty formula** for **how to calculate IRR** (and the commentary from Investopedia):

No one is going to want to take on that **beast of a formula** by hand.
So, obviously, **IRR **is a completely **different animal than annual return** and the two have nothing to do with each other.

## So how do I use IRR properly?

IRR is only intended to be used **to compare with other IRR's**. In other words, a 10% IRR is a higher return than a 5% IRR and vice versa. **That's it**. It is **not **supposed to be used to **compare **with **annual **returns.

Or to put it another way: a **10% IRR** does **not** necessarily **mean a higher return** than a 5% annual return. **Maybe** it is and maybe it isn't. But you **can't compare** the two because they are **entirely different measurements**.

**It's like trying to ask whether 10 inches is more or less than 5 hours. **It's a **nonsensical** question. because the two metrics have nothing to do with each other.

But many investors **don't realize** the above. And that can get them into **trouble** when looking at deals.

## When calculating from "gross" can get gross

**Virtually every responsible sponsor** will report the **IRR** as "**net**". This means that it is the IRR the investor gets ** after all of the sponsor fees, profit splits** etc.
However,

**occasionally**a sponsor will

**only report**the

**IRR**as "

**gross**". This means

**all of those fees and profit splits are**

*before***deducted**. And when

**that**happens, it's a

**pet peeve**of mine, because the investor

**needs**the

**to do their**

*net*IRR**due diligence**. I personally will always go back to the sponsor and try to

**ask**for the

**net IRR**before going further. But I've seen that many investors believe that they can

*create**a*

**homegrown calculation**where they

**calculate the NET IRR themselves**by

**mixing IRR's with annual percentages**. And when they do, they can go

**dangerously**

**off the tracks**.

**Another situation** where I've seen this happen is when a **sponsor reports both gross and net **and the investor believes that as part of due diligence they will

**"reconcile"/double-check**the

**difference**. Again, they do this by

**mixing IRR with annual percentages**and they get into the exact

**same trouble**.

## "Show me the numbers!"

I'll give you an **example **of **how to calculate IRR** the **wrong way vs the right way**. (And the huge **difference **between the two).

Let's say an investor's looking at a deal that **projects a 10% gross IRR**, and they want to figure out the

**. They don't understand that**

*net*IRR**IRR**and

**annual return**are completely

**different things**and

**should not be mixed**together in a calculation.

**Here's what they will do:**

(For this example, I assumed a **typical private equity structure** with 2% management fee and a waterfall with an 8% preferred return, return of capital and 80% investor/20% sponsor split. I also assumed a pretty **typical case **of several capital calls occurring in the first couple of years, an initial "dry period" of no distributions for 2 years, and then distributions which increase from there...but are not entirely the same amount each time).

This was really **easy to calculate** because **all** they did was **subtract percentages from IRR's**. The** "answer"** they got is **7.6% net IRR**. And unfortunately it's **way off** from the accurate answer.

**Here's how to **** calculate it the right way**.

(**It's** **a lot of work.** You must load every single **capital call and distribution** into a **spreadsheet**; **subtract **out the **management fee**, which is pretty quick and easy, and then the **sponsor split**, which is a little bit more work; and finally, **run the IRR formula** on it -- and thank the Excel makers that you don't have to do the **recursive formula** by hand. Also, it's important to **remember** to use the **XIRR function**, aka the *variable date IRR feature*, of the spreadsheet, versus just the **plain IRR function**. The plain IRR function will give **inaccurate answers** because the **capital contribution and distribution dates** aren't at **100% regular intervals**.)

After taking the time to do the above, **the actual answer is 4.9% net IRR**. So that's a **big difference** from the** homegrown answer** of **7.6% net IRR**.

In this **particular** case, the investor's **mistake **might've caused them to **take on** **a** **lot more risk** than they realized. But this isn't always the case, and **in some situations** they might **under-calculate the actual return**. In that case, they might **unnecessarily pass on a deal** that **actually met** their **requirements**.
And as you can see, doing it **right** is a **lot of work**. So whenever I run into an investor who tells me, **"I quickly did an IRR calculation** and it says..." it brings up an** immediate yellow flag** for me. In general, there is **no such thing** as a **quick IRR calculation**, and they are probably making an **inaccurate calculation**.

## Can IRR and annual return *ever* be the same?

**Rarely, yes**,** internal rate of return** and **annual return** are pretty much the **same **thing.

An **example **is a **CD** **where**:

**All money**is**put in entirely**at the**very beginning**.The

**distributions**are going to be the**exact same amount**and made at**exactly regular intervals**.

In **this case**, the **net IRR** and the **annual percentage** are probably going to be **the same **or at least **pretty close**.

**But**, **almost no alternative investment** **is exactly like that**.

Many times, the

**money isn't**put in via a**lump sum**at the**beginning**.**Instead**, the money is collected from the investor in**smaller chunks**(called "**capital calls**") that might be**spread over a time**period as long as**1-5 years**.Many times, the

**distributions**are very**different**from a CD's, and**aren't**going to be**exactly the same amount each time**. There may be an**initial period**at the**beginning**where there are**no distributions expected**at all (the "**dry period**"). When they**do**start, many times they**start off lower**and then**increase**(the "**ramp up**"). And many times, the**final distribution**is expected to be**many times larger**than anything made previously.

So, this is why **mixing IRRs and annual percentage returns** is usually a **dangerous** thing to do.