IRR is a vanity metric for VC Funds
sethlevine.com
sethlevine.com
These points describe a different problem - that you can't condense something complicated like a fund down to a single number, so you shouldn't view IRR in isolation. I suspect (hope) people sticking money into VC funds are sophisticated to know that though.
This isn't unique to IRR. If you stock pick looking only at P/E ratios you're gonna have a bad time too
But let's also not forget that in many cases these funds are driven by their investors to focus on IRR. Many times these funds do not cater towards retail investors. The problem is therefore coming from the institutional side where people seem to be pushing these metrics.
It's like instead of counting how much customer are paying, we measure sign-ups, page visits, time on page, whatever. At times, these proxy metrics is the only thing we have so it is better than not having a metrics at all.
Npv/economic value added/etc. will yield one level per investment. And while you can sum these values for an aggregate, it’s not helpful to compare the npv of one investment for the other, because the fact that you have an NPV limits the risk of misinterpreting the investment as SCALEABLE. Some opportunities truly are finite, and cannot scale up—but if I were using irr to measure the value of selling my daughter painted Easter eggs, you’d think I have an investment of a lifetime—only to realize she has $35 stashed away, and is 10+ (hopefully 20+) years away from applying for credit!
I think that makes sense anyway.
Or, I don't know either and can't believe it is not explained at all in the article. Guess we're not the target audience.
That said I've never quite understood the specific pros/cons behind favoring IRR over other metrics.
This post also talks about “Interim IRR” (I’ve also heard it called “paper IRR”), which a lot of funds report based on the current marked up valuation of the portfolio. It’s what the IRR would be if everything could be liquidated based on the current last/valuation. Which has never made any sense to me and seems like pure vanity if not actively disingenuous. You’re not liquid. You’ve not provided any cashflow returns. There is no IRR yet.
But I guess people need a way to justify their paper performance.
If it takes $100 one year to return $110, then the irr is 10%, because a 10% interest rate would cause you to owe $10 at the end of the first year, which is exactly equal to cash generated.
Irr usually takes average accounting income per year in the denominator e.g. $10 in our case, and divided by the investment size.
Note: an investment that yields $5 at the end of each of two years is more attractive than one that pays $10 at the end of two years. Both have average accounting income of $5 per year, and the IRR is the same for each investment!!!!!! NPV scores the first incessant higher than the later--yet another reason why irr is a bad metric
VC is an outliers domain, a few outliers will define the success of your fund or not. As a result as IRR is annualized, it can gives you the impression that you are successful even though you are not. But actually IRR is a good metric especially for funds that invest in a lot of deals per year, because you can see if a fund is consistently performing over the years.