INTERNAL RATE OF RETURN IS JUST ONE TOOL TO MEASURE PERFORMANCE, LIKE JUDGING A 12-20 PITCHER BY HIS GREAT ERA: TOO NARROW A FOCUS IS JUST IRRATIONAL

Imagine for a moment that you are a baseball fanatic who, by a stroke of incredibly good luck, has been granted the wish of a lifetime: You can manage one of two major league baseball teams.

One team has a platoon of hitters with great batting averages, and pitchers who have amazingly low earned-run averages. These guys are terrific ballplayers, with the stats to prove it.

The other team will win the World Series.

Not really a tough choice, is it?

For most of us, baseball — like investing — is about winning, not about stats. In sports, an excessive focus on arcane performance measures is a harmless diversion.

But there is a real risk when investors make the same mistake, and use IRR as the lodestone of their investment compass.

IRR is the internal rate of return, or the discount rate at which the present value of the future cash flow matches an investment’s cost.

Private equity and hedge fund investors often look at the track records of general partners and fund-of-funds managers, expressed in terms of IRR, to determine whether they have been successful at their chosen strategies.

It is certainly wise for investors to look at track records. IRR, accurately disclosed in strict compliance with Association for Investment Management and Research standards, is a valuable yardstick for investors.

Furthermore, track records which have been independently verified by a Big Five accounting firm can provide investors with important assurance that claimed results reflect actual performance.

More important to the investor than IRR is the multiple of dollars returned.

Given the choice, would you rather have an investment that generates an IRR of 500% or one with an IRR of 50%?

The answer seems simple.

Of course 500% is better than 50%. But the all-important missing element in the question is time.

A $100 investment that has a 500% IRR over the course of one week will generate a gain of about $10. That same $100 invested at a 50% IRR for a full year will produce a gain of $50. Now which investment is preferable, the one with a 1.1 multiple of capital generated or the one with a 1.5 multiple?

The simple truth is you can’t eat IRRs. The purpose of investing, after all, is to accrete wealth, not to accumulate a scorecard of interesting statistics. Unfortunately, most of us tend to think of percentages assuming that they are presented in a common frame of reference. It is natural, therefore, to assume that IRRs as quoted are an apples-to-apples comparison.

Too often, unfortunately, that isn’t the case.

Another fact of life for the investor is that it is difficult to find good investments. The longer the period of time for which money can be placed in a good investment that yields a high return, the more wealth can be created.

To go back to the example above, a $100 investment that generates a $10 gain in a week must be reinvested to keep earning returns. If it does nothing but hold its value from that point onward for the next 51 weeks, the investment’s annual return is only 10%, rather than the 500% IRR of the first week.

An investment manager continually faced with reinvesting a portfolio may run increased risks to generate high IRRs. Here, as always, you can’t identify the winner until the race is over.

When evaluating a portfolio manager’s performance, IRR should be looked at as just one of a broad range of factors

A key measure is the multiple of capital generated. One also should look closely at how the IRRs and multiples were generated, and especially at the risks the manager took to generate those returns.

It is often those factors — how the game is played, not what the player’s statistics are — that is the best predictor of future wins.

Christopher J. Bower is the founder and chief executive of Pacific Corporate Group, a private equity investment advisory firm in La Jolla, Calif. This article originally appeared in the firm’s newsletter, Private Equity Investor.