What Is Net Internal Rate of Return – Net IRR?
Let me explain what net internal rate of return, or net IRR, really is. It's a performance measurement that takes the internal rate of return and adjusts it after factoring in fees and carried interest. You use it in capital budgeting and portfolio management to figure out an investment's yield or overall financial quality by calculating an expected rate of return.
In practice, net IRR is the rate where the net present value of your negative cash flows equals the net present value of your positive cash flows. You'll see a net internal rate of return expressed as a percentage.
Key Takeaways
- Net internal rate of return (Net IRR) gauges the performance of a project or investment based on its discounted future cash flows.
- Net IRR starts with traditional IRR and then accounts for fees, costs, carried interest, and other deductions that standard IRR ignores.
- By including costs and fees, net IRR provides you or managers with a more accurate view of an investment's real potential.
The Basics of Net IRR
The IRR is essentially a discount rate where the present value of future cash flows from an investment equals the investment's cost. Net IRR modifies that IRR value by considering management fees and any carried interest.
In general, a higher net internal rate of return means it's a better investment for you. That said, a slightly lower net IRR over a longer period can outperform a higher one in a shorter term.
Net Internal Rate of Return Put to Use
When you calculate a fund's net internal rate of return, it helps you as an investor or analyst decide which investment is the best. If you have two funds with the same investments and strategy, you'd logically pick the one with lower fees.
But don't assume structural similarity and fees alone make one fund superior. You can only confirm that by calculating the net IRR for both. The lower-fee option might not always be the winner.
Real-World Example of Net IRR: Net IRR and Private Equity
Net internal rate of return is widely used in private equity to analyze projects that need regular cash investments over time but end with a single cash outflow, like an initial public offering, merger, or acquisition.
If the investment's net present value matches or exceeds the net present value of benefits or the acceptable rate of return, the project is profitable. When two projects have the same net IRR, go for the one with the shorter time frame—it's considered better.
Back in 2014, the Securities and Exchange Commission (SEC) started investigating if private equity fund managers were properly disclosing their own invested capital in net IRR calculations. Including that 'general partner commitment' could inflate performance artificially since it doesn't come with fees.
How firms perform net IRR calculations—whether including general partner capital or not—varies, as Reuters discovered. The SEC requires private equity firms to clearly report both average net IRRs and gross IRRs in all fund prospectuses and marketing materials.
