MOIC vs IRR: Assessing Private Equity Performance

How do private equity managers rank themselves in the industry? What measures of performance should investors look to prioritize before committing to a manager? Why are there so many terms to describe performance?

Investors must grapple with many questions before determining whether to allocate to private equity, but one of the most frequently asked questions revolves around returns and performance evaluation. The most common performance metrics for private equity are:

• Multiple on Invested Capital (MOIC) or Total Value to Paid-in-Capital (TVPI)
• Internal Rate of Return (IRR)

Below are breakdowns of the calculations, along with a comparison of MOIC vs. IRR.

MOIC and TVPI can be used interchangeably and measure performance without factoring in time.

MOIC or TVPI = (DPI + RVPI) / Total Dollar Amount Invested

• DPI is an abbreviation of Distributions to Paid-in-Capital. Investors receive distributions from private equity managers as investments come to fruition, most notably when a private equity manager sells an investment, thereby realizing the value.
• RVPI is an abbreviation for Remaining Value to Paid-in-Capital. This can also be thought of as unrealized value or the Fund’s Net Asset Value (NAV).

Ex: If an investor contributes $100 to a fund and the total value is $300, the MOIC or TVPI is 3.0x. The multiple does not consider when the return is achieved, but rather how much the invested capital is worth. The $300 could be returned in 5 years or 3 years. When holding the MOIC constant, the length of the holding period impacts the IRR.

IRR is a calculation that looks at when money is invested and returned to clients. IRR uses the present sum of cash contributed, the present value of distributions, and the current value of the unrealized investment.

NPV = net present value

CF = Cash Flow

T = Time

R = rate of return

Per Investopedia: “The ultimate goal of IRR is to identify the rate of discount, which makes the present value of the sum of annual nominal cash inflows equal to the initial net cash outlay for the investment.”

Ex: If an investor contributes $100 to a fund, which is valued at $300 after three years, the IRR is approximately 44.27%, whereas if the investment had a total value of $300 after five years, the IRR is approximately 24.57%.

At a high level, investors can think of IRR as the annualized rate of return, meaning the return an investor receives each year. IRR places an emphasis on not only how much is returned but also when the money is returned.

When comparing MOIC vs. IRR, time can play a big role in assessing performance. Since IRR uses time as part of its calculation, if a fund’s life is drawn out, then the IRR will subsequently be lower. In the example above, if an investor’s $100 investment has a total value of $300 after 5 years, the investor will have tripled their investment, otherwise known as 3x MOIC. The tripled investment after 5 years translates to an IRR of 24.57%. If the investment was valued at $300 after three years, then the IRR would be 44.27%, which is almost 20 percentage points higher per year compared to the 5-year period.

When holding the MOIC constant, investors will always choose the higher IRR. However, there are situations where investors may earn high IRRs in a short period of time resulting in a low MOIC. For example: if an investor earns a 10% return in a 6-month period, their MOIC is 1.1X and their IRR is approximately 21.32%. In these types of low MOIC scenarios, investors may need to continue to find new investments at similar IRRs to generate higher MOICs. While some investors do not mind this process of churning through multiple investments, others would prefer not to have to recycle their capital. For example, if an investor wanted to earn a 2X MOIC on their investment they would need to hold an investment with a 21.32% IRR for approximately 3.59 years.

These examples illustrate the importance of considering both MOIC and IRR when assessing an investment’s performance.

Increasingly, managers have been using credit facilities to delay capital calls early on in the life of their funds. Before the use of credit facilities, managers would issue a notice, known as a capital call notice, requesting investors to provide the funds needed for an investment once a deal has been struck.

Capital call credit facilities allow fund managers to draw on a line of credit to make an investment, delaying the need to make a capital call to their LPs. A credit facility allows managers to use a set schedule and “smooth” capital calls on, say, a semi-annual or quarterly basis, for capital calls. For institutional investors with large private equity portfolios, this enables them to better plan their cash flows due to the predictability of capital calls.

With credit facilities, the manager can delay capital calls until the credit facility needs to be paid down. As discussed earlier, time significantly impacts IRR calculation. Managers using credit facilities will report a higher IRR, compared to managers that don’t, as seen in the below example.

For example, let’s say an investment manager closed on an investment on January 1st, 2021. The investment manager invests $100, which 5 years later end up being worth $500. The Manager can either issue a capital call that is due by January 1st to Fund the acquisition or delay the capital call with its credit facility.

If the manager uses a credit facility to delay the capital call by 1 year, the IRR would be approximately 49.5%. If the manager doesn’t use a credit facility and calls the capital upfront the IRR is approximately 38%. When comparing MOIC vs. IRR, the IRR calculation is exposed to more manipulation with time.

While this example above does not consider the impact of the credit facilities’ interest expense on the MOIC, there will generally be a small negative impact on the MOIC of the Fund. However, this negative impact is very small relative to the positive impact on IRR.

Together, MOIC and IRR can help paint a better picture when evaluating performance. MOIC illustrates the total return of an investor’s dollars over the life of an investment. Conversely, IRR considers the time value of money. When holding IRR constant, more time allows for a higher MOIC. When holding MOIC constant, less time results in a higher IRR. When assessing whether to use MOIC vs. IRR for private equity performance, investors can consider both measures in their evaluation process.