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.
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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?