Net Internal Rate of Return: Definition, Uses, and Example

What Is Net Internal Rate of Return – Net IRR?

Net internal rate of return (net IRR) is a performance measurement equal to the internal rate of return after fees and carried interest are factored in. It is used in capital budgeting and portfolio management to calculate an investment's yield or overall financial quality by calculating an expected rate of return.

Practically, net IRR is the rate at which the net present value of negative cash flow equals the net present value of positive cash flow. A net internal rate of return is expressed as a percentage.

Key Takeaways

  • Net internal rate of return (Net IRR) is a way of gauging the performance of a project or investment based on its discounted future cash flows.
  • Net IRR takes traditional IRR and then accounts for the effects of fees, costs, carried interest, and other deductions that IRR would typically overlook.
  • Because it factors in costs and fees, net IRR gives investors or managers a more accurate picture of an investment's actualized potential.

The Basics of Net IRR

The IRR is a discount rate where the present value of future cash flows of an investment is equal to the cost of the investment. The net IRR is a modified IRR value that has taken into consideration management fees and any carried interest.

Generally, a higher net internal rate of return means that it is a better investment. However, a marginally lower net IRR spread over a longer time period can be superior to a shorter-term, higher net IRR investment.

Net Internal Rate of Return Put to Use

Calculating a fund's net internal rate of return can help an investor or analyst determine which investment is the best option. Given a pair of funds that hold the same investments and are managed using the same strategy, it would be wise to consider the one with the lower fee.

But structural similarity and fees are not enough to prove that one fund is better than another. That can only be learned by calculating the net IRR for both funds. The one with the lower fee may not necessarily be the best choice.

Real-World Example of Net IRR: Net IRR and Private Equity

Net internal rate of return is commonly used in private equity to analyze investment projects that require regular cash investments over time but offer only a single cash outflow at its completion – usually, an initial public offering, a merger or an acquisition.

If the investment's net present value is the same as the net present value of benefits, or if it surpasses the acceptable rate of return, the project is considered profitable. If two competing projects turn out to have the same net internal rate of return, the one with the shorter time frame is considered the better investment.

In 2014, the Securities and Exchange Commission (SEC) began investigating whether private equity fund managers were correctly disclosing their own invested capital into their own funds when performing net internal rate of return calculations. Including that sum—known as a "general partner commitment"—could artificially inflate fund performance because such capital infusions do not have fees attached to them.

How net IRR calculations are performed (whether they include general partner capital or not) varies among private equity firms, Reuters found. The SEC expects private equity firms to clearly report both average net IRRs and gross IRRs on all fund prospectuses and marketing material.

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