Andras Crow-Hreidar 
Making money on private equity investments is a tricky business. Successful deals require the right timing, accurate market projections, and an understanding of the key metrics used to assess performance. Two such important indicators are MOIC (Multiple on Invested Capital) and IRR (Internal Rate of Return). Both can provide investors with meaningful insights into their own return potential and managerial evaluation for investment firms. In this blog post, we’ll take a deep dive into these crucial measures – exploring how they work in tandem to identify great investments and indicate successes in private equity investing.
What Is MOIC?
The MOIC is a finance metric that stands for “Multiple of Invested Capital.” It’s widely used in private equity or venture capital to measure the profitability of an investment. Private equity or venture capital funds use the money they receive from investors to invest in privately held companies. They aim to help these companies to grow and sell them for a higher price to make a profit. MOIC is a measurement tool that quantifies the return the investors got on their initial investment.
To determine the MOIC, you need to divide the total amount of money returned to the investor, including any distributions, by the amount of money they initially invested. So if an investor initially invested $100,000 and ultimately received $500,000 in total distributions, their MOIC would be 5x. A high MOIC indicates a successful investment as the investor received a return that was multiple times their initial investment. Conversely, a low MOIC implies that the investment wasn’t as successful.
Investors in private equity or venture capital funds use the MOIC as an important metric to assess the fund’s performance and compare it against other investment opportunities. Although MOIC is useful, it does not factor in the time value of money or investment risks. Other metrics should also be considered to evaluate investment or fund performance correctly.
What Is IRR?
The abbreviation “IRR” means “Internal Rate of Return.” This term is used in finance to gauge an investment’s profitability over time. The IRR calculates the interest rate at which the total value of all cash flows from the investment equals zero. This measure is widely used in evaluating the potential profit of an investment in private equity and venture capital. The IRR accounts for the time value of money, which means it considers the decreased worth of money received in the future due to inflation and other factors.
In order to determine the IRR, you must have information about the investment’s cash flows, including the initial investment and any future cash inflows and outflows. The cash flows can be either positive (income earned) or negative (expenses incurred). The IRR is the discount rate that makes the net present value of all the cash flows equal to zero.
Calculating the IRR involves a formula, but it’s usually done with a financial calculator or spreadsheet program. Keep in mind that IRR is a complicated metric, and slight changes in cash flows or discount rates can have a big impact on the result. If IRR is high, it means the investment is profitable, as the returns are higher than the capital cost. In contrast, a low IRR indicates a less-profitable investment.
Investors in private equity or venture capital use the IRR to assess the potential profitability of an investment and compare it to other opportunities. It is an important metric but should be used alongside other metrics, like the MOIC, to evaluate the overall performance of an investment or a fund.
Key Differences Between MOIC and IRR:
Two metrics used to assess the performance and profitability of an investment in private equity or venture capital are MOIC and IRR. Although both are essential, there are significant distinctions between them.
- Calculation method: To calculate MOIC, divide the total money returned to investors by the amount they originally invested. On the other hand, to calculate IRR, find the discount rate at which the present value of all cash inflows equals the initial investment.
- Focus on time: MOIC emphasizes the return on the initial investment, whereas IRR factors in the timing of cash flows received and considers the time value of money. IRR is a time-weighted metric.
- Sensitivity to cash flows: Compared to MOIC, IRR is more affected by the timing and amount of cash flows received. Even slight adjustments in the cash flows or discount rate can lead to notable fluctuations in the IRR, while MOIC is less affected by such variations.
- Usefulness for different purposes: The MOIC metric is suitable for assessing how well a fund or investment performs throughout its lifespan, whereas the IRR metric is more appropriate for evaluating individual investments’ profitability over time.
To summarise, MOIC and IRR are vital metrics for assessing investment or fund performance. However, they have distinct advantages and limitations and are used for different objectives. To evaluate an investment or fund’s comprehensive performance, it’s crucial to comprehend and use both metrics alongside other metrics.
Limitations and Criticisms of MOIC and IRR:
While MOIC and IRR are popular and widely used metrics in private equity and venture capital, they are not without limitations and criticisms. Here are some of the key limitations and criticisms:
- Incomplete picture of investment performance: The use of MOIC and IRR may not provide a complete picture of an investment’s performance as they do not factor in certain elements such as the investment’s risk level, cash flow size and timing, and the influence of external factors such as the economy and changes in regulations.
- Sensitivity to assumptions: The calculations for MOIC and IRR are highly dependent on the assumptions used, including the discount rate applied to compute the current value of future cash flows. Even minor adjustments to these assumptions can lead to notable changes in the final metrics.
- Biased towards shorter holding periods: Investments with shorter holding periods are preferred by MOIC and IRR due to giving more importance to earlier cash flows than later ones, which could lead to an inaccurate assessment of the investment’s long-term performance.
- Lack of comparability: It can be challenging to compare the MOIC and IRR of various investments or funds since they don’t consider variations in the investment’s risk profile, timing and size of cash flows, and the influence of external factors.
- Overemphasis on financial metrics: In the end, relying too heavily on MOIC and IRR may result in a neglect of significant aspects like ESG matters and sustainability in the long run.
In evaluating the performance of private equity and venture capital investments, it’s important to consider other metrics alongside MOIC and IRR and to be aware of the limitations and biases of these two metrics.
Final Words:
Ultimately, the success of a private equity investment can be assessed using two metrics – MOIC and IRR. While both metrics are important, understanding their differences is key, as they offer complementary yet distinct perspectives on an investment’s success. Both measures must also be viewed in the context of their associated assumptions. With these considerations taken into account, investors will be well equipped to use MOIC and IRR to measure their private equity investments against established benchmarks and determine the future suitability of their portfolios. Ultimately, the success of any private equity investment can depend considerably on effectively evaluating it and adjusting accordingly. As such, gaining experience in applying and measuring each metric can provide beneficial insights when assessing potential investments and confidence when considering exits or refresher investments.
