IRR vs. TVPI – what are the key differences?
Alternative Investments are considered non-traditional assets requiring unique performance metrics to understand their value-add to portfolios. Different methods of computing performance help investors understand the return and cash profile of alternative investments. Two of the more commonly used performance metrics for alternative investments are the "TVPI" and the "IRR." Each is acceptable but can lead to significantly different interpretations based on one's perspective.
Internal Rate of Return
Internal Rate of Return or ‘IRR’ is the discount rate applied to all future cash flows that produce a net present value of zero. Once the IRR is determined, it can be compared to other funds' IRR to get a sense of how each investment has performed. IRR are often compared to a predetermined hurdle rate. A hurdle rate is a minimum return required by an investor for the risk assumed. For example, the average annualized total return for the S&P500 index over the past 90 years is 9.8%. This annual return might be considered a hurdle rate for investments with similar risk profiles since there would be no benefit to participating in investments if it couldn't outperform the index. A significant benefit of using IRR as a performance metric is that it can take a set of irregular cash flows and estimate the percentage yield of those cash flows over the investment's lifetime. However, the timing of cash flows is critical. The IRR is highly sensitive to cash flows early in an investment's life cycle, and can, therefore, create a scenario where the IRR remains overstated in later years.
Total Value to Paid-in Capital
The "TVPI" is the "Total Value to Paid-in Capital" ratio. This ratio has other names, including Multiple of Investment Cost (MOIC) and the Return on Invested Capital (ROIC). TVPI is simply the total estimated value of an investment divided by the total capital invested. The total value is made up of all distributions, plus the unrealized value remaining in the investment. Paid-in Capital is the capital that has been contributed to an investment (aka a sum of all capital calls). A major benefit of this metric is that it is straightforward and may be calculated by anyone if they know the primary inputs. However, it is important to understand that the TVPI does not consider the timing of cash flows. For example, if an investment has a TVPI of 1.5x after two years, it has performed much better than a different fund with a TVPI of 1.5x after six years.
Bottom Line: Both methods of performance have advantages and disadvantages. Both are widely used in performance measurement of alternative assets, and investors need to have a basic understanding of each. It is also important to utilize each in tandem to get a clear picture of how well an investment has performed. When investors understand the advantages and disadvantages of each, it leads to more informed decisions that hopefully lead to better returns.
