February 11, 2019
Multiple of Invested Capital (“MOIC”) and Internal Rate of Return (“IRR”) are two metrics that are used in private equity to calculate an investor’s return on investment. However, that’s where the similarities end. Read on to learn more about how MOIC and IRR are two different, but important, metrics in private equity.
MOIC
MOIC is a quick indicator of the return on your investment. Another way to think about this is that it shows the total value of a portfolio. In quantifying this return, the metric focuses on how much rather than when.
For example, using the equation above, if I invested $100 and my total value is $500, the MOIC is 5x. You’ll notice that time was not factored into this calculation. Two deals with an MOIC of 5x have the same return regardless of when they achieve it.
IRR
IRR, on the other hand, is a different measure of return. Conceptually, IRR is the interest rate (r) that sets the net present value (NPV) of cash flows (CF) to zero. You’ll notice that IRR focuses on how much and when.
For example, if I invested $100 and five years later my total value is $500, the IRR is 37.9%. You’ll notice that for IRR, time was factored into this calculation. Two deals with the same MOIC most likely will have different IRRs due to when investors receive the return. For instance, in our previous example, if it took ten years to generate the 5.0x MOIC rather than five years, the IRR would drop to 17.4%. Obviously, that’s still a great return for the investor. But, tells a slightly different story as it incorporates the effects of time.
MOIC and IRR
MOIC and IRR are both valuable to investors. MOIC’s simplistic calculation clearly tells investors how much money they’re ultimately receiving from an investment. On the other hand, IRR allows for investors to understand the impact of varying hold periods on investment returns. However, investors should be aware that a high IRR over a shorter hold period might be inflated from a recent acquisition and is unsustainable in the longer term. Additionally, the IRR calculation assumes distributions are reinvested at the same IRR.
For example, when an investor is presented with a 35% IRR return, this might seem great! However, if you learn that same investment achieved a 1.3x MOIC, this could imply that the GP received a quick return on LP capital. Now, the LP has to figure out how to redeploy into the market, which often comes at a cost.
MOIC and IRR: Our Thoughts
Our advice, think about MOIC and IRR as different parts of a bigger picture. Neither guarantees success. Each has its respective shortcomings.
When evaluating an investment opportunity, consider what each metric is and is not telling you. Most LPs consider both metrics alongside other factors such as time horizon, risk profile and DPI/RVPI.
For a more in depth understanding of MOIC, please review our blog post.
