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<h2 style="line-height:1.38; margin-top:24px; margin-bottom:5px">What is the internal rate of return (IRR)?</h2>

<p>Venture capital firms use the internal rate of return (IRR) metric to analyze a fund&rsquo;s performance and give the annualized percentage returns earned by the fund. IRR is also used to estimate the potential yield from the investments before the fund matures.&nbsp;</p>

<p>A high IRR can indicate a potentially sound investment opportunity.&nbsp;</p>

<h2>Why do GPs use IRR to evaluate returns?</h2>

<p>General partners (GPs) use the IRR metric to calculate returns as venture investments remain illiquid for longer periods and have fluctuations due to varying startup valuations. Due to the opportunity cost of capital and the time value of money, GPs prefer this metric as it takes into account the initial investment, expected cash flow, and timing of cash inflows and outflows. GPs prefer the IRR metric because it allows them to compare the fund performance of different classes of assets with varying vintage years.&nbsp;</p>

<p>Due to the risker nature of venture investments, funds typically have a high IRR. Seed-stage funds typically aim for a 30% IRR while later-stage funds target a 20% IRR, typically over an eight-year horizon. GPs use the IRR metric along with the <a href="https://inside.com/glossary/T/tvpi">Total Value Paid In (TVPI)</a>&nbsp;metric to accurately understand a fund&#39;s performance. TVPI and IRR are inversely related. The IRR is able to provide an accurate comparison for two funds with different vintage years, unlike TVPI since it does not consider the timing of cash flows. However, for funds with same vintage years, TVPI provides a helpful comparison.</p>

<p>Future IRR predictions are used by GPs to persuade limited partners (LPs), such as endowments and pension funds, to participate in the fund. LPs consider the historical IRR figures of the firm before investing in the fund.&nbsp;</p>

<h2>How to calculate IRR</h2>

<p>The IRR is the rate of discount required to ensure that the present value of potential future returns equal to the initial investment. IRR is the rate of returns when the present value of future cash inflow will equal the initial investment. In other words, it is the rate when the net present value is equal to zero.&nbsp;</p>

<p>The IRR takes into account net cash inflow, initial investment, and the time period of investment.&nbsp;</p>

<p>When investments have not yet been realized, fund managers need to calculate the unrealized IRR, while when they are completed, they need to calculate the realized IRR. In order to calculate the unrealized IRR, the current value of assets is used, as if they were going to be liquidated at the time of calculation. The realized IRR can only be calculated once the investors receive their distributions.&nbsp;</p>

<h2>Ways to measure IRR</h2>

<p>The IRR can be measured as gross or net IRR. Gross IRR, otherwise known as deal IRR, measures the return on the entire fund&#39;s portfolio. This indicator is used to assess the GP&#39;s performance and the returns they are able to deliver from the investments. The Net IRR metric is used to measure the return on investment after subtracting VC fees, such as management fees and <a href="https://inside.com/glossary/C/carried-interest">carried interest</a>.</p>

<h2>What are the limitations of IRR?</h2>

<p>The IRR calculations can vary heavily based on the timing of fundraising, capital deployment, and period of returns. The IRR calculations can also look inflated if the valuations of the portfolio assets have been overestimated. Cash flow estimates, NPV, and discount rates can influence the IRR calculations.&nbsp;</p>

<p>The IRR values on their own only provide half the picture while evaluating funds. Investors should consider the size of the initial investment to avoid making poor investments.&nbsp;</p>

<h2>IRR returns for VC funds</h2>

<p>Buyout and late-stage venture capital firm TPG reported IRR ranging from 6% to 36% between 2007 and 2020, per SEC filings reviewed by Titan. The funds were averaging returns of 15%.&nbsp;</p>

<p>In Jan. 2023, Business Insider reviewed internal documents of Union Square Ventures (USV) that showed that the venture firm returned an average of&nbsp;<a href="https://inside.com/vc/posts/union-square-ventures-delivers-59-irr-to-utimco-344182">59% IRR</a> to limited partner University of Texas/Texas A&amp;M Investment Management Company (UTIMCO). Documents show that UTIMCO invested $130M into the firm over the years. At the end of the fund&#39;s tenure, UTIMCO was able to walk away with $1.2B. UTIMCO invested $22M into USV&#39;s 2004 fund which generated $305M in returns, representing an IRR of 66%.&nbsp;</p>

<p>Public filings of the California Public Employees&#39; Retirement System (CalPERS) showed that its capital deployment into VC funds between 2000 and 2020 yielded <a href="https://inside.com/vc/posts/calpers-vc-investments-in-last-two-decades-yield-0-49-returns-349588">0.49% IRR</a>. CalPERS invested $75M and $25M into NEA and DCM&#39;s funds in early 2000s, which earned 2.7% and 1.9% returns, respectively. Its $260M investment into two venture funds launched by Khosla Ventures yielded 11.5% and 6.9% IRR, well below the benchmark figures of 14.7% for vintage funds that started in the same year.&nbsp;</p>

<p>In Q2 2022, IRR for global venture funds dipped into the negative territory to -2.3%, per Pitchbook&#39;s 2022 Global Fund Performance report. In the same period a year ago, VC funds were averaging 71.4% IRR.</p>


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Internal rate of return

What is internal rate of return, and why do GPs use it to evaluate a fund's performance?

<h2 style="line-height:1.38; margin-top:24px; margin-bottom:5px">What is the internal rate of return (IRR)?</h2>

<p>Venture capital firms use the intern

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