IRR measures the speed of money, not the amount: test it against the hurdle, the index and the peers, and always read it with the multiple.
A good net IRR for a private equity fund is one that clears three bars at once: the fund's own hurdle, typically 8 per cent; the public market over the same dates; and the median of its vintage peers. It is never good on its own. In an illustrative comparison, a fund with a 21.3 per cent IRR and a 1.50x multiple ranks top quartile, yet a fund at 15.6 per cent and 2.10x made more than twice the profit and beat the public market by more: a PME of 1.35 against 1.25.
Worked in full in Private Equity Investor Relations by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The question arrives in every first meeting with a new limited partner, and in a different form in every investor relations interview: is this a good number? The honest answer is a short calculation, not a threshold. IRR measures the speed of money, not the amount, and a fund that returns cash quickly can post a high rate on a modest profit. The comparison below is the one an experienced investor runs in its head.
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 |
|---|---|---|---|---|---|---|---|---|
| Fund X | -50 | -50 | 60 | 90 | 0 | 0 | 0 | 0 |
| Fund Y | -40 | -35 | -25 | 0 | 20 | 40 | 70 | 80 |
Both funds are fully realised and both flows are net of fees and carry. The hurdle is 8 per cent. The public index is assumed to return 9 per cent a year. Peer thresholds for the vintage are illustrative: upper quartile 18 per cent, median 13 per cent, lower quartile 7 per cent. Real benchmarks come from a data provider and differ by vintage and strategy, as explained in how quartile rankings are calculated.
Net IRR: the rate r at which Σ CFt ÷ (1 + r)t = 0
Multiple = distributions ÷ contributions; profit = distributions − contributions
Kaplan-Schoar PME = PV of distributions at the index return ÷ PV of contributions at the index return
In Excel, with flows in B2:I2: =IRR(B2:I2) for the IRR; =NPV(9%,B2:I2)*(1+9%) for the net present value at the index return, which is positive when the fund beat the market; and the PME as the ratio of the two present values. Use XIRR and the actual index series for a real fund.
Bar 1, the hurdle. Both funds clear 8 per cent comfortably. At the hurdle rate, Fund X's flows are worth 26.6 per $100 committed and Fund Y's 38.9.
Bar 2, the public market. Discount each fund's flows at the index's 9 per cent. Fund X's net present value is 24.1 and its PME 1.25; Fund Y's is 32.5 and its PME 1.35. Both beat the market, but Y by more, even though its IRR is 5.7 points lower.
Bar 3, the peers. X at 21.3 per cent is above the illustrative upper quartile of 18 per cent. Y at 15.6 per cent is second quartile, above the 13 per cent median.
| Measure | Fund X | Fund Y |
|---|---|---|
| Net IRR | 21.3% | 15.6% |
| Spread over the 9% index, points | 12.3 | 6.6 |
| Quartile (illustrative) | Upper | Second |
| Net multiple | 1.50x | 2.10x |
| Profit | 50.0 | 110.0 |
| Average years capital outstanding | 2.10 | 5.15 |
| Kaplan-Schoar PME at 9% | 1.25 | 1.35 |
| Net present value at 9% | 24.1 | 32.5 |
Fund X's IRR is higher because its capital was out for 2.10 years on average, against 5.15 for Y. X's rate only matters if the investor can put the returned cash back to work at a similar rate, which it cannot do on demand: in practice it waits in cash, or in the index at 9 per cent. On that basis Y created more value, 32.5 against 24.1 per $100, and more than twice the profit. Comparing IRR spreads over the index flatters X, because it compares rates earned over very different periods.
| Final distribution | Net IRR | Multiple | PME |
|---|---|---|---|
| 40.0 | 11.4% | 1.70x | 1.11 |
| 60.0 | 13.6% | 1.90x | 1.23 |
| 80.0 | 15.6% | 2.10x | 1.35 |
| 100.0 | 17.3% | 2.30x | 1.47 |
A 20-point change in a single late exit moves Y's IRR by about 2 points and its multiple by 0.20x. At 1.70x and 11.4 per cent, Y would sit below the illustrative median and barely beat the market, a PME of 1.11. A good IRR for a long-duration fund needs a high multiple behind it; a short-duration fund can reach the same IRR with much less.
An unrealised fund's IRR is softer still. At year four, with a net asset value of 110.0 and only 20 distributed, Fund Y showed an IRR of 8.6 per cent, a TVPI of 1.30x and a DPI of 0.20x: a fund that ended up returning 2.10x looked mediocre at mid-life. When an IRR becomes meaningful is worked in when a fund's IRR becomes meaningful.
The mistake is to answer the question with a single threshold, such as "anything above 20 per cent", and to rank funds by IRR alone. That rewards speed over value, and it can be engineered with a subscription line or early partial exits. Present net IRR together with the multiple, DPI, the PME against a stated index and the quartile against a stated benchmark, and say which vintage and strategy the benchmark covers. The same fund stated six ways is in six ways to state a fund's return.
A good IRR is relative: above the hurdle, above the public market over the same dates, above the vintage median, and backed by a multiple that shows the profit is real. If the IRR is high and the multiple is low, ask how long the money was out. The workbook that computes every one of these measures on one set of cash flows is in the free workbook for this case.
It can be, if it clears the hurdle, beats the public market over the same dates and sits above the vintage median, and if the multiple is solid. In the illustrative case a fund at 15.6 per cent and 2.10x is only second quartile on IRR but beats a 9 per cent index with a PME of 1.35, better than a 21.3 per cent fund at 1.50x.
Because IRR rewards speed. Capital returned after two years earns a high rate on a small profit. The illustrative Fund X returned 1.50x with capital out for 2.10 years on average and posted 21.3 per cent; Fund Y returned 2.10x over 5.15 years for 15.6 per cent. Unless the cash can be reinvested at the same rate, the higher multiple creates more value.
Not directly, because an IRR is money-weighted and an index return is time-weighted. Use a public market equivalent instead: discount the fund's flows at the index return. At an illustrative 9 per cent, the fund with a 21.3 per cent IRR has a PME of 1.25 and the 15.6 per cent fund 1.35, the opposite ranking to their IRR spreads.
This article is one calculation from Private Equity Investor Relations. 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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