Alternatives Knowledge Base

Internal Rate of Return (IRR)

Properties2
descriptionThe annualised rate of return that equates the present value of all cash flows in a fund to zero – the primary performance metric in private equity.
tagsirr, internal-rate-of-return, performance, private-equity

5 min read

Internal Rate of Return (IRR)

Definition

The Internal Rate of Return (IRR) is the annualised discount rate at which the net present value (NPV) of all cash flows into and out of a fund equals zero. Put simply: it is the rate that makes what you put in worth exactly what you got back, after accounting for when each cash flow occurred.

Formula: IRR is the rate r solving:

0 = Σ [ Cₜ / (1 + r)ᵗ ]

Where Cₜ is the net cash flow at time t (negative for capital calls, positive for distributions). In practice, use Excel’s XIRR function (which handles irregular dates) rather than the date-assumption-sensitive IRR function.

Why It Matters

IRR is the primary performance metric for closed-ended alternative investment funds because it accounts for both the size of returns and the timing of cash flows. A fund that returns 2× invested capital in 3 years is far more valuable than one achieving the same multiple in 10 years. IRR captures this time dimension; MOIC does not.

IRR is used:

  • As the headline fund-level return metric reported to LPs in quarterly and annual reports
  • As the primary metric against which hurdle rates and carried interest are measured
  • For benchmarking against public market equivalents (see PME) and peer funds of the same vintage year

Gross IRR vs Net IRR

This distinction matters more than almost any other in PE metrics. Always establish which basis you are reading before drawing conclusions.

  • Gross IRR – Calculated before management fees, fund expenses, and carried interest. Reflects the GP’s investment performance in isolation.
  • Net IRR – Calculated after all fees and carry. This is what LPs actually earn and is the correct basis for comparing funds from an investor’s perspective.

The gap between gross and net IRR is material. In a standard fee structure, net IRR is commonly 2–4 percentage points lower than gross IRR. The precise gap depends on the fee level, fee basis, offset provisions, and the timing and magnitude of carry. No universal rule applies.

When reviewing any IRR figure, ask: Is this gross or net? Net to the fund or net to the LP after taxes?

Fund IRR vs LP IRR

These are not the same metric, and the difference is operationally significant:

  • Fund IRR – Calculated using the fund’s internal cash flows: the dates capital is deployed into investments, and the dates proceeds are received from exits. Ignores the timing of LP capital calls.
  • LP IRR – Calculated from the LP’s perspective: the dates the LP actually transferred cash to the fund (capital calls) and received cash back (distributions). This is what an LP’s portfolio system should report.

When a fund uses a subscription line facility (short-term borrowing to bridge investments before calling LP capital), the Fund IRR and LP IRR diverge significantly. The fund deploys early but calls LP capital weeks or months later, shortening the period over which LP capital is at risk and inflating LP IRR. A fund might report LP IRR of 18% when the underlying investment performance (Fund IRR using actual deployment dates) is closer to 14%. This is not fraudulent – it is disclosed – but it can make performance comparisons misleading. ILPA guidance recommends reporting both IRR with and without subscription line effects.

Worked Example: IRR vs MOIC

An LP commits to a fund. Cash flows are:

DateCash FlowType
Year 0–£2.0mCapital call
Year 1–£3.0mCapital call
Year 2–£3.0mCapital call
Year 3–£2.0mCapital call
Year 5+£3.0mDistribution
Year 7+£8.0mDistribution
Year 9+£7.0mDistribution

Total invested: £10.0m. Total returned: £18.0m.

  • MOIC = £18.0m / £10.0m = 1.8× (straightforward)
  • IRR ≈ 12% per annum (accounts for timing; calculated by XIRR)

Now imagine the same returns but distributions are delayed by 2 years (all exits come 2 years later):

  • MOIC = 1.8× (unchanged – MOIC ignores time)
  • IRR ≈ 9% per annum (materially lower because returns came later)

This illustrates why IRR and MOIC must be read together: MOIC tells you how much money was made; IRR tells you how fast.

When IRR Is Unreliable

IRR has specific weaknesses that readers must understand:

  • Early-stage funds. For a fund that is 1–4 years old, IRR is highly sensitive to small changes in quarterly NAV. An IRR of 25% in Year 2 tells you almost nothing about final returns. Early IRR should be interpreted with extreme caution.

  • Funds with significant remaining NAV. If a fund still holds 60% of its portfolio at cost or estimated value, the IRR is partially based on unverified paper gains. The RVPI component could compress sharply at exit (see RVPI).

  • Subscription lines. As described above, bridging facilities can meaningfully inflate reported IRR. Always ask whether the IRR is reported before or after subscription line adjustment.

  • Cannot be averaged or added. You cannot meaningfully average IRRs from two funds weighted by commitment. Fund-level and portfolio-level IRR require proper time-weighted cash flow aggregation.

  • Multiple solutions. If a fund’s cash flows change sign more than once (unusual but possible with recycling), there may be more than one mathematically valid IRR. Most software takes the first solution found.

Manual Review Notes

  • The gross-to-net fee drag range of “2–4 percentage points” is illustrative; actual impact varies significantly by fund size, deployment pace, and carry trigger timing. Review periodically as market fee norms evolve.
  • Subscription line practices are regulated and disclosed requirements vary by jurisdiction. ILPA guidance (public) recommends dual reporting. Verify that ILPA guidance remains current before citing.
  • XIRR vs IRR distinction should be tested practically – some teams default to IRR without adjusting for irregular dates.

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