Research Digest | Private Equity's IRR Problem

What's new: A new paper from Oxford's Ludovic Phalippou reveals how the private equity industry's preferred performance metric - Internal Rate of Return (IRR) - has created an illusion of superior returns, driving massive capital inflows.

Why it matters: The industry has grown fifteen-fold over 25 years, partly based on reported IRRs of 30-90% that mathematically cannot reflect actual investor returns. When Yale claims a 93% annual venture return, it would turn $1 million into $191 trillion - twice global GDP.

Big picture drivers:

• IRR calculations assume early distributions are reinvested at the same high rate until fund end

• Large early distributions can "lock in" high IRRs that persist regardless of later performance

• Fund managers can manipulate IRR through quick exits and subscription credit lines

By the numbers:

• PE firms report 25-39% IRRs over decades

• Reality check: Industry-wide data shows 9.1% median IRR

• True outperformance vs S&P 500 is just 1.4% annually

• Fund giant KKR's post-1999 net IRR: 12.3% vs pre-1999: 20%

Key trends to watch:

• Growing push for "horizon IRRs" limited to 5-20 year periods

• Calls to rename IRR as "Internal Discount Rate" to reduce confusion

• Increased focus on money multiples alongside IRR

• Regulatory scrutiny of performance reporting practices

The bottom line for investors: The private equity industry's headline-grabbing returns often reflect mathematical quirks rather than realized performance. Thorough due diligence should focus on actual cash returns and use IRR as just one of multiple metrics.

Read Full Paper