Private Equity's IRR Illusion Exposed by Oxford Professor

What's New

In a recent Financial Times piece, Oxford professor Ludovic Phalippou mathematically dismantled private equity's favorite performance metric, revealing that Internal Rate of Return (IRR) calculations are fundamentally flawed and deliberately misleading. Major firms like KKR claim 25.5% gross IRRs since 1976, while Apollo boasts 39% gross returns—numbers that would theoretically create impossible wealth levels exceeding global GDP if actually sustained.

Why It Matters

The widespread misuse of IRR distorts trillions of dollars in investment decisions and gives private equity an unfair advantage over other asset classes. As retirement funds prepare to open to ordinary investors, this mathematical sleight-of-hand could mislead millions of Americans into believing they're accessing Warren Buffett-beating returns when the reality is far more modest.

Big Picture Drivers

• Mathematical manipulation: IRR assumes unrealistic reinvestment rates and becomes "fixed" after early successful exits, barely changing regardless of subsequent performance

• Survivorship bias: Only firms with good early exits survive to report long-term IRRs, creating an illusion that 20-30% returns are standard across the industry

• Strategic gaming: Fund managers deliberately exit successful investments early and retain underperformers to artificially inflate IRR calculations

• Regulatory gaps: No requirements exist to report more meaningful metrics like net multiples or rolling-period returns that would reveal true performance

• Fee justification: Sky-high IRRs help justify the industry's premium fee structure, the highest margins in financial services

By The Numbers

• $2.6 trillion: What KKR's first $31 million fund would theoretically be worth today at claimed 26% annual returns

• $74 trillion: Apollo's first funds' theoretical value at claimed returns—nearly matching global GDP

• 12%: KKR's actual 20-year rolling IRR, far below the claimed 25.5% since-inception figure

• $203.4 billion: Total KKR investments since 1976, becoming $381.9 billion by 2024—a more realistic 1.9x multiple

• 35.1%: Example IRR that remains virtually unchanged whether final portfolio value is $100 million or $100 billion

Key Trends to Watch

• Horizon IRRs are emerging as more realistic alternatives, showing 10-15% returns over rolling 20-year periods rather than inflated since-inception figures.

• Multiple on Invested Capital (MOIC) disclosures are increasing, though most firms still report gross figures that exclude fees paid by investors.

• Regulatory scrutiny is intensifying as retirement funds prepare for private equity access, potentially forcing more transparent reporting standards.

• Academic pressure is mounting to rename IRR as "Internal Discount Rate" to reflect its true mathematical function rather than misleading "return" terminology.

The Wrap

Private equity's performance theater relies on a mathematical trick that sophisticated institutional investors may understand but will likely bamboozle ordinary retail investors. With the multitrillion-dollar retirement market potentially opening to private equity, investors need to demand rolling-period returns and net multiples instead of since-inception IRRs to make informed decisions about this high-fee asset class.