What is the difference between IRR and MOIC?
MOIC is total proceeds divided by investment and ignores time. IRR is the annual return that sets NPV to zero. 2x in two years is about a 41% IRR, while 3x in five is about 25%, so they can rank deals differently.
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Example answer
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MOIC is the multiple of invested capital. It's the money you got out divided by the money you put in. IRR is the internal rate of return, which is the percentage return on the investment each year. The difference is time. MOIC tells you how much money you made and ignores how long it took. IRR tells you how fast you made it. Private equity firms care most about IRR because it's the more accurate measure. Ideally you'd want both to be high.
What holds it back
Both definitions are roughly right and time is named as the difference, but there are no numbers. It also calls IRR the more accurate measure, which isn't true. Each one answers a different question.
MOIC is the multiple of invested capital. It's the money you got out divided by the money you put in. IRR is the annual return that takes time into account. Formally it's the discount rate that makes the net present value of all the cash flows equal zero. The difference is time. MOIC tells you how much money you made and ignores how long it took. IRR tells you how fast you made it. Say I invest $100 and get back $200. That's 2x either way. Over three years it's about a 26% IRR, and over five years it's about 15%. The two can disagree. Take one deal that returns 2x in two years and another that returns 3x in five years. The first has an IRR of about 41% and the second about 25%. So IRR prefers the first deal and MOIC prefers the second. That's why private equity firms look at both. IRR rewards getting money back early, and MOIC shows the dollars created.
MOIC is the multiple of invested capital. It's the money you got out divided by the money you put in. IRR is the annual return that takes time into account. Formally it's the discount rate that makes the net present value of all the cash flows equal zero. The difference is time. MOIC tells you how much money you made and ignores how long it took. IRR tells you how fast you made it. Say I invest $100 and get back $200. That's 2x either way. Over three years it's about a 26% IRR, and over five years it's about 15%. With one cash flow in and one out I can do that in my head, because IRR is the multiple raised to one over the number of years, minus one. Tripling in five years is about 25%. The two can disagree. Take one deal that returns 2x in two years and another that returns 3x in five years. The first has an IRR of about 41% and the second about 25%. So IRR prefers the first deal and MOIC prefers the second. Which one is better depends on what I can do with the money after year two. If I can't put it back to work at a similar rate, I'd take the 3x, because $100 becomes $300 and not $200. That's why private equity firms look at both. IRR rewards getting money back early, and MOIC shows the dollars created. IRR can also be pushed up without creating any value, for example with an early dividend or a quick sale. So I'd quote the two together with the holding period, and I'd be wary of a high IRR on a low multiple.
The numbers, step by step
One $100 investment, with a single cash flow in and a single cash flow out, held for different lengths of time.
- Multiple on $100 in, $200 out$200 / $100
- 2.0x
- IRR for 2x in three years2 ^ (1/3) − 1
- about 26%
- IRR for 2x in five years2 ^ (1/5) − 1
- about 15%
- IRR for 3x in five years3 ^ (1/5) − 1
- about 25%
- IRR for 2x in two years2 ^ (1/2) − 1
- about 41%
What the interviewer listens for
- Can you define each one in a sentence without mixing them up?
- Do you say that time is the difference?
- Can you turn a multiple and a holding period into a rough IRR?
- Do you know a case where the two rank deals differently?
- Do you know how IRR can be flattered?
Common mistakes
- Saying IRR is simply the better measure.A 41% IRR on a deal held for two years can leave fewer dollars than a 25% IRR held for five.
- Dividing the total gain by the number of years.Doubling in five years is about 15% a year, not 20%, because the return compounds.
- Defining both correctly and stopping there.The follow-up is nearly always a number, so have 2x and 3x over three and five years ready.
- Forgetting that the shortcut only works for one cash flow in and one out.With dividends along the way, IRR has to be solved from all the cash flows.
More finance technicals
- Where do the returns in an LBO come from?
- Walk me through the sources and uses in an LBO.
- What is a dividend recapitalization, and why would a private equity firm do one?
- What kinds of debt are used in an LBO?
- How do you decide how much debt a company can support?
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