IRR (Internal Rate of Return)

The internal rate of return (IRR) is the annualised rate at which the net present value of a fund's cash flows equals zero, expressed as a percentage return per year. It is the primary time-weighted performance metric for private funds and the standard by which GPs report returns to LPs, compare performance against benchmarks, and compete for capital in subsequent fundraises.

How it works

IRR is calculated by solving for the discount rate that makes the sum of the present value of all cash outflows (LP capital contributions) equal to the sum of the present value of all cash inflows (distributions and residual NAV). Unlike a simple percentage return, IRR accounts for the timing of cash flows: money returned earlier contributes more to IRR than the same amount returned later, because of the time value of money.

For private funds, the relevant cash flows are: capital calls from LPs (negative cash flows, as they represent money leaving the LP's account), distributions to LPs (positive cash flows), and the residual NAV of the fund (treated as a hypothetical distribution at the reporting date for the purpose of calculating interim IRR). The calculation is performed at the fund level and, in more detailed reporting, at the individual LP level (since different LPs may have joined at different closings and therefore have different cash flow profiles).

IRR has two important variants in private fund reporting. Gross IRR is calculated before management fees and carried interest and represents the return generated by the investment portfolio itself. Net IRR is calculated after management fees, carried interest, and fund expenses and represents the actual return delivered to LPs. The difference between gross and net IRR (typically 3-7 percentage points depending on fund terms and performance) reflects the full cost of fund management. LPs benchmark net IRR against the relevant vintage year peer group.

The most significant operational variable affecting IRR is the timing of capital calls. Because IRR is measured from the date of LP cash outflows, compressing the period between investment and capital call increases IRR without changing the underlying investment return. Subscription lines are used partly for this effect: by delaying capital calls, the effective investment period appears shorter, and IRR appears higher. ILPA guidance requires GPs to disclose both a subscription-line-adjusted IRR and a non-adjusted IRR so LPs can compare on a consistent basis.

Worked example

Castlefield Capital Fund II makes the following cash flows with LP Eta (GBP 10M commitment, first close):

Year 0: capital call GBP 2.5M (25% of commitment). Year 1: capital call GBP 2.5M. Year 2: capital call GBP 2M; distribution GBP 1.5M. Year 3: distribution GBP 4M. Year 5 (end): distribution GBP 9M (final realisation); remaining NAV GBP 0.

Net cash flows from LP Eta's perspective: -2.5, -2.5, -2M+1.5M = -0.5, +4M, +9M.

Solving for IRR: the discount rate that makes the NPV of these flows equal to zero. Using a financial calculator or iterative method, the IRR is approximately 22.4% per annum (net of fees and carry already deducted from distributions in this illustration).

The fund administrator calculates IRR at each reporting date using actual dated cash flows from the ABOR, not estimated or rounded flows. Small errors in contribution or distribution dates have a material effect on IRR in high-return scenarios. LP reporting includes the IRR calculation methodology and the cash flow schedule used, so LPs can verify the output.

Frequently asked questions

What is the difference between IRR and MOIC/multiple? IRR is time-sensitive: it penalises investments that take longer to return capital, even if the eventual return is large. MOIC (multiple of invested capital) measures the total cash returned divided by total cash invested, regardless of timing. A fund that returns 3x in three years has a much higher IRR than a fund that returns 3x in ten years, even though the MOIC is identical. LPs use both metrics together: MOIC shows total value creation; IRR shows the pace at which it was created.

What is a "good" IRR for a private fund? Benchmarks vary by asset class and vintage year. For institutional PE buyout funds, top-quartile net IRR is typically in the 20-25%+ range; median funds deliver 12-17% net IRR. Private credit funds target lower IRRs reflecting their lower risk profile, typically 8-15% net. VC funds have a wider range of outcomes. Comparing IRR across asset classes is misleading without adjusting for risk; comparing IRR across vintage years without controlling for market conditions is also unreliable. Cambridge Associates, Preqin, and Burgiss publish vintage year benchmarks for meaningful peer comparison.

How does subscription line usage inflate reported IRR? A subscription line delays the LP capital call from the date the investment is made to the date the line is repaid. IRR is measured from the date of LP cash outflow, not from the date of investment. Compressing the gap between investment and LP payment shortens the effective holding period in the IRR calculation and increases the annualised rate. The investment performance is unchanged; only the reported metric improves. ILPA guidance requires disclosure of both adjusted and unadjusted IRR to prevent misleading comparisons between funds with different subscription line usage.

What is the difference between net IRR and gross IRR? Gross IRR is calculated on the cash flows of the fund's investment portfolio before any fees or carry. Net IRR is calculated on the cash flows actually received and paid by LPs, after management fees, carried interest, and fund expenses. Fund marketing materials often lead with gross IRR; LPs care about net IRR. The difference can be 3-7 percentage points. When comparing managers, always confirm whether a quoted IRR is gross or net.

Does IRR work well for private credit funds? IRR is less central in private credit than in PE. Credit funds often target consistent income returns rather than lumpy equity realisations, making MOIC less meaningful and IRR less variable across the fund's life. Credit fund performance is more commonly benchmarked using yield metrics (net yield, spread over a reference rate) or against liquid credit indices. IRR is still calculated and reported, but it is not the primary performance narrative for a senior secured credit strategy.

Related terms

MOIC (Multiple of Invested Capital), TVPI, DPI and RVPI, J-curve, Preferred return, Hurdle rate, Carried interest, Subscription line, Capital account, Vintage year

Related pages

Performance reporting for private fund administrators, Swelv for fund administrators