A fund's IRR is earned on capital while it is invested. The LP's return is earned on everything it set aside, including the years that money waits for calls.
Cash drag is the gap between a fund's IRR and the return on all the capital an LP sets aside for the commitment. On an illustrative 100 committed to a fund returning 12.0 per cent, with uncalled capital and distributions held at 4 per cent, the 100 set aside earns 7.0 per cent a year over 12 years, 5.0 points below the fund. About 3.1 points come from waiting for calls and 1.9 from distributions waiting to be reused.
Worked in full in The Private Markets Limited Partner by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
An IRR measures the return on capital while it is inside the fund. The LP's investment committee cares about something else: what the money reserved for private equity actually earns. Over a fund's life, a commitment is fully invested for only a few years. Before that the money waits for calls; after that it comes back faster than it can be recommitted. The calculation below follows one commitment through its whole life and keeps every unit of the reserve in the sum, wherever it happens to sit. It is a different drag from the one inside a semi-liquid fund, where new subscriptions wait in cash before they are deployed, worked in how much cash drag subscriptions cause in an evergreen fund.
| Input | Value |
|---|---|
| Commitment, all of it held in reserve at year 0 | 100 |
| Calls, years 1 to 5 | 25, 25, 20, 15, 10 |
| Called in total | 95 |
| Fund NAV growth before distributions | 12% |
| Distributions, years 4 to 12 | 173.0 in total |
| Fund TVPI / IRR | 1.82x / 12.0% |
| Yield on uncalled capital and distributions | 4% |
Liquid balancet = balancet−1 × 1.04 − callt + distributiont
Return on commitment = (final balance ÷ 100)1/12 − 1
In Excel, with calls in C3:N3, distributions in C4:N4 and 100 in B5: =B5*1.04-C3+C4 across the row, then =(N5/B5)^(1/12)-1. The fund IRR on its own is =IRR(C4:N4-C3:N3) with a zero in year 0.
Follow the 100 through the fund's life. It starts entirely in cash, is mostly in the fund by year 3, and is mostly back in cash by year 8.
| Year | Liquid balance | Fund NAV | Total | Share in the fund |
|---|---|---|---|---|
| 1 | 79.00 | 25.00 | 104.00 | 24% |
| 3 | 39.45 | 79.36 | 118.81 | 67% |
| 5 | 42.27 | 100.44 | 142.70 | 70% |
| 6 | 66.46 | 89.99 | 156.45 | 58% |
| 8 | 123.48 | 59.26 | 182.75 | 32% |
| 12 | 225.22 | 0.00 | 225.22 | 0% |
The 100 ends at 225.22, a multiple of 2.25x over 12 years, or 7.0 per cent a year. The fund made 78.0 of profit and the liquid balance earned 47.25 of interest. Averaged over the 12 years, only 33 per cent of the money was in the fund, which is why a 12.0 per cent asset produces 7.0 per cent on the capital behind it. The drag is 5.0 points.
Split it in two. If the reserve earns 4 per cent only until called, with the 17.07 left in the reserve after the last call released in year 5 and distributions counted as they arrive, the return is 8.9 per cent: 3.1 points of drag from waiting for calls. The remaining 1.9 points come from distributions, and the part of the reserve never called, sitting in liquid assets until year 12. In a running programme those distributions fund the next vintages, so the first part is the one a single fund cannot avoid and the second is the one the programme design removes.
| Yield on liquid assets | Final balance | Return a year | Drag |
|---|---|---|---|
| 0% | 177.97 | 4.9% | 7.1 |
| 2% | 199.55 | 5.9% | 6.1 |
| 4% | 225.22 | 7.0% | 5.0 |
| 6% | 255.88 | 8.1% | 3.9 |
The other lever is commitment size. Commit 130 for every 100 held in reserve and the same 12 years produce 244.76, 7.7 per cent a year. The price is the cushion: the lowest liquid balance falls from 34.91 to 10.29, in a base case in which calls and distributions arrive on schedule. How far that can go before a stressed year exhausts the reserve is worked in what overcommitment ratio a programme can afford.
Investing the reserve in listed equities instead of cash raises the expected return on the waiting money but makes it least available when it is most needed: calls tend to keep coming when public markets fall and distributions slow. Model the reserve at the return of the assets that will still be there in a stressed year, and treat any extra yield as a bonus rather than as part of the plan.
The common mistake is presenting the fund's net IRR as the return of the private equity allocation. An LP that commits 100, keeps the uncalled amount in cash and reports 12.0 per cent has reported the return on 33 per cent of its money. The capital behind the commitment earned 7.0. Both figures are correct; they answer different questions, and the board is usually asking the second one.
The opposite mistake is to treat cash drag as an argument against private equity. It is an argument for programme design: a steady commitment pace, an overcommitment ratio set against a stressed liquidity forecast, and distributions recycled into new commitments. Each of those raises the share of the reserve that is invested without changing the fund at all.
Measure the return on everything set aside for a commitment, not only on what was called: here 7.0 per cent against a 12.0 per cent fund IRR, a drag of 5.0 points split between waiting for calls and holding distributions. The free workbook for this case works the related arithmetic of NAV-years per unit committed, and the blank version takes your own programme.
The return lost because capital committed to a fund is not invested in it all the time. The LP holds the uncalled amount in liquid assets before calls and receives distributions it must reinvest. With a 12.0 per cent fund and 4 per cent on cash, 100 committed earns 7.0 per cent a year over 12 years: 5.0 points of drag.
By putting more of the reserved capital to work. Committing 130 for every 100 held in reserve lifts the 12-year return on the reserve from 7.0 to 7.7 per cent in the illustration, but the lowest liquid balance falls from 34.91 to 10.29, so the reserve has far less room for calls that come early or distributions that come late.
Yes, almost point for point on the part held in liquid assets. Raising the yield on uncalled capital and distributions from 0 to 6 per cent moves the return on 100 committed from 4.9 to 8.1 per cent, and the drag against the 12.0 per cent fund IRR from 7.1 to 3.9 points.
This article is one calculation from The Private Markets Limited Partner. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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