To enable the gross and net Internal Rate of Returns (IRRs) to be comparable, all relevant components (variables) must be treated in an identical manner. It is for this reason that the standard principles have been developed, which are set out below.
Gross Internal Rate of Return (IRR)
This measures the return earned by the fund from its investments, and takes account of:
- All the cash outflows (investments) and inflows (divestments, including realisation values, interest and dividends, repayments of principal of loans, etc.) which take place between the fund and all of its investments, independently, whether realised or not;
- The valuation of the unrealised portfolio. By definition, the unrealised portfolio excludes cash and other assets held by the fund.
This return does not include the impact of carried interest or charges of any kind, such as management fees paid to the private equity firm by the investor, fees paid by a portfolio company either to the fund or the private equity firm, and fees paid or due to lawyers, accountants and other advisers (except where such fees specifically relate to a particular investment).
Fund Net Internal Rate of Return (IRR)
This measures the return earned by the investors in the fund, and takes account of:
- The actual cash flows which take place between the fund and all the Limited Partners (LPs);
- The LPs’ share of the fund’s remaining net assets, which includes the valuation of the unrealised portfolio, cash and other net assets or liabilities, after an appropriate accrual for carried interest.
When the portfolio is fully realised/fully distributed, the fund net IRR reflects the ‘cash-on-cash’ return to the investors, and will implicitly be net of:
- The management fees paid to the fund manager (whether funded from investor drawdowns or out of investment income);
- The fund manager’s carried interest;
- All other applicable professional and ancillary charges which are paid out by the fund in the course of investing, managing, and divesting from the investment portfolio.
The fund net IRR should accordingly represent a “blended” net IRR of all the investors. It is noted that this figure may be greater than or less than the net IRR attributable to an individual investor.
Net Internal Rate of Return (IRR) to an individual LP
This is calculated as for the fund net IRR, but based on the cash flows, carried interest and valuations attributable to the individual LP.
It should be noted that net IRR can only be calculated for an entire interest in a fund and not for individual investments. Deal-by-deal net IRRs would require allocations of costs and fees and are thus not typically appropriate measures of performance.