Correcting Alpha: Fundamental Flaws of IRR and How Sponsors Can Avoid Distorted Calculations (Part One of Two)

Although it is the primary comparative performance metric used in the PE industry, the formula for calculating a fund’s internal rate of return (IRR) has several inherent and material flaws. When coupled with some of the natural fund management techniques and efforts of sponsors, those flaws can produce IRR distortions that draw unwanted attention from prospective investors and, potentially, the SEC. To help sponsors mitigate these risks, this first article in a two-part series describes some of the flaws of the IRR formula and prescribes specific measures general counsels and chief compliance officers of managers can undertake to ensure the accuracy of their IRR calculations. The second article will suggest ways prospective investors can perform their own diligence of IRR figures during the fundraising process to acquire the most accurate picture possible of a sponsor’s investment acumen and performance record. See our three-part series on ways IRR calculations can be distorted: “How Omitted Inputs and Deferred Carry Can Inflate IRR Calculations” (Sep. 10, 2019); “How Fund Management Practices Affect IRR Figures” (Sep. 17, 2019); and “How Curated Past Performance Results Can Produce Misleading IRRs” (Sep. 24, 2019).

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