Returns may be measured in a number of ways, in compliance with reporting best practices.
One may, for example, measure the payback period, that is to say the number of years required for the expenditure associated with a project to be recouped; or one might measure the book rate of return, this being the average annual profit made by an investment as a proportion of the original outlay.
Each of these simple techniques exhibits serious deficiencies however. For example, payback does not consider the total profit which may be earned; neither method accounts for the time value of money or for situations in which more than one investment is made.
Another common measure of performance is the internal rate of return (”IRR“).
Industry-wide private equity performance studies throughout the world use the IRR, to the extent that it has become the undisputed best practice standard for performance monitoring in private equuity.
The IRR is that rate of discount which equates the present value of the cash outflows associated with an investment with the sum of the present value of the cash inflows accruing from it and the present value of the valuation of the unrealized investment. Not only does this measure take the time value of money into account, as well as the ability to measure the returns on groups of investments, but it also expresses the return as a simple percentage.
Other frequently used best practice measures of performance are the multiples to investors of:
• distributions to paid-in capital;
• residual value to paid-in capital;
• total value to paid-in capital.
In this section we will discuss: