IRR and multiple of invested capital (MOIC)

Which return measure do private equity and real estate use?

Private equity and real estate funds draw capital over several years and pay it out at irregular dates, so a single period return does not describe them. Two measures are standard. The internal rate of return (IRR) uses every cash flow and its date. The multiple of invested capital (MOIC) is a quick shortcut that ignores dates.

Return measures for long-lived alternativescash goes in and out at irregular times

• Internal rate of return (IRR) Memorize the preferred measure
  • Considers timing of cash flows Memorize rewards or penalizes the manager for timing decisions
  • Harder to calculate Memorize needs a financial calculator
  • Needs assumptions Memorize a financing rate for outflows and a reinvestment rate for inflows
• Multiple of invested capital (MOIC) Memorize a shortcut also called the money multiple
  • Easy to calculate and explain Memorize "we got 2× our money"
  • Ignores timing Memorize 2× in 2 years is not 2× in 15 years

How do you calculate the IRR of a deal?

The IRR is the discount rate that sets the present value of all the cash flows to zero. It is the same idea as the money-weighted return from the rates and returns module, and the same as the capital budgeting IRR in Corporate Issuers.

$$\sum_{t=0}^{n} \frac{CF_t}{(1 + IRR)^t} = 0$$

The manager decides when to call capital and when to return it. The timing of cash flows is therefore part of the manager’s skill, and IRR is the yardstick that rewards or penalizes it.

IRR assumes outflows are financed at some rate (often a weighted average cost of capital) and inflows are reinvested at some rate, which may or may not be earned in practice. Those assumptions affect the answer.

How do you calculate MOIC?

MOIC, also called the money multiple, divides everything the investment is worth by the money put in. The realized value is cash already received from exits and distributions. The unrealized value is the estimated worth of what is still held.

$$\text{MOIC} = \dfrac{\text{Realized value} + \text{Unrealized value}}{\text{Invested capital}}$$

The denominator is invested capital : the paid-in capital less management fees and fund expenses, so only the money that actually went into investments.

$$\text{Invested capital} = \text{Paid-in capital} - \text{Fees and expenses}$$

MOIC is easy to calculate and easy to say: investors like to hear that they received two or three times their money. But it says nothing about how long that took.

Why does the time frame matter?

A multiple on its own can hide a very different yearly return. If a single investment returns a multiple $M$ after $T$ years with nothing paid out in between, the equivalent yearly return is $M^{1/T} - 1$.

$$r = \text{MOIC}^{1/T} - 1$$

The same logic shows up inside one deal. If the sale proceeds of 75 in the first example arrive in year 6 instead of year 5, the cash flows are −40, −10, 0, 0, +15, 0 and +75. MOIC stays at 1.80×, but the IRR falls from 13.52% to 11.40%. MOIC counts the money; IRR also counts the years.

Exam tip When a question gives a multiple and a holding period, convert before comparing. When it gives uneven cash flows, use the cash flow worksheet.

Go deeper Limits of IRR

IRR depends on the reinvestment and financing assumptions described above, and a set of cash flows that changes sign more than once can have more than one IRR. These issues are covered with capital budgeting in Corporate Issuers. For this module, remember the contrast: IRR counts timing but is harder to calculate and needs assumptions; MOIC is simple but blind to time.

Go deeper Why the middle of a fund's life is hard to read

After a private equity fund has called all its commitments, interim accounting values matter less for a while because no cash moves on them. Values may then sit near cost with only small adjustments until an impairment or a sale. The unrealized part of MOIC therefore rests on Level 3 estimates, so treat an interim MOIC with caution.