IRR stands for internal rate of return, and PE firms use this metric to judge the return on an investment.
IRR is the annualized return of the equity investment, and is equal to the CAGR of the equity investment until exit, assuming no other interim cashflows before the sale of the company, such as dividend recapitalizations or equity calls (additional equity investments).
IRR can also be defined as the discount rate that makes the NPV (net present value) of the firm equal to zero.
Calculation
IRR can be calculated using the CAGR (compounded annual growth rate) formula, which is equal to (ending equity at time of sale / initial equity invested) ^ (1 / number of years) – 1. However, as mentioned previously, we can only use this formula if there are no interim cash flows.
When there are interim cash flows, IRR needs to be calculated with an Excel formula: =IRR(select series of annual cash flows).