How is the commitment-weighted IRR calculated?

• A. By averaging returns across all portfolios
• B. By weighting rates of return according to commitment
• C. By pooling cash flows at different times
• D. By estimating future growth rates

Answer: (B)

The commitment-weighted internal rate of return (IRR) is calculated by weighting rates of return according to the capital commitments made by investors. This method takes into account the amount of capital that has been committed to an investment over time, reflecting the timing and size of cash flows associated with that capital. The formula for commitment-weighted IRR essentially adjusts the cash flows based on the proportion of total commitments, allowing for a more accurate representation of an investor's effective return based on their contributions.

This approach contrasts with simple averaging of returns or pooling cash flows without considering their timing and size, which could lead to misleading interpretations of performance. By focusing on the commitments, the commitment-weighted IRR becomes a more relevant measure, especially in private equity or venture capital contexts where investment contributions can vary significantly among investors. Thus, weighting rates of return according to the commitment aligns the IRR more closely with the actual economic experience of the investors.