1. 64 • CFA Digest • May 2009
”2009 CFA Institute
The Hazards of Using IRR to Measure
Performance: The Case of Private Equity
Ludovic Phalippou
Journal of Performance Measurement
vol. 12, no. 4 (Summer 2008):55–67
Internal rate of return (IRR) is defined as the discount rate that
makes the net present value of a series of cash flows equal to
zero and is widely used by private partnerships as a perfor-
mance measure. IRR, however, has its own shortcomings and
biases and creates room for managers to manipulate the
performance reporting. The author presents the pitfalls of IRR
and shows how a modified IRR can be implemented at the
investment and fund level.
The author illustrates the problems with the internal rate of return
(IRR) by using hypothetical cash flows from four funds (X, Y1, Y2,
and Z) with the same initial investment of $100 million. Fund X
returns $150 million after one year and then $50 million in the third
year. As a result, the investment is doubled and has an IRR of 68
percent. Funds Y1 and Y2 return $100 million after five years and
another $100 million in the eighth year. Both Y1 and Y2 have also
doubled the investment, but their IRRs are only 11 percent. Fund Z
returns $50 million in the fifth year and $10 million in Year 12,
registering an IRR of –8 percent.
The IRR equals the effective rate of return, however, only if interme-
diary cash flows are reinvested at the IRR rate. If an investment is
volatile and produces significant intermediary cash flows, the IRR will
not be a good proxy for performance. For example, in the case of Fund
X, the $150 million it received in Year 2 needs to be reinvested at 68
percent per year for the investors to receive an effective return of 68
percent. If the reinvestment rate of 68 percent is not feasible, the IRR
exaggerates the performance of the fund.
Ludovic Phalippou is at the University of Amsterdam Business School. The summary
was prepared by Lester C. Cheng, SG Cowen Securities Corp.

2. Performance Measurement and Evaluation • 65
www.cfapubs.org
The dispersion of performance is overstated when the IRR is used to
compare the performance of various funds because researchers and
practitioners assume that high-IRR funds have high effective rates of
return and low-IRR funds have lower effective rates of return. The
true spread, nevertheless, depends on the reinvestment rate. When
the author calculates that rate by replacing the IRR with the estimated
average market return as the reinvestment rate, the spread between
the best and worst funds shrinks dramatically.
Averaging IRRs can also be misleading. The average IRR for the four
hypothetical funds mentioned earlier is 21 percent, but the IRR for
the aggregated cash flows is only 12 percent. A combined investment
in these funds will simply not earn an average IRR of 21 percent.
Some researchers have also found that private equity performance is
negatively related to duration and average performance is substan-
tially biased upward. This correlation and bias may be related to
managers cutting good investments early to achieve a high IRR.
Another way to attain a high IRR is to distribute a large dividend
early, but this approach also destroys the value of the investment.
Finally, because the IRR will not significantly change when managers
exit investments in the final years, they may underprice an IPO in
exchange for favors, such as media coverage.
The author claims that modified IRR (MIRR) is a better measure for
private investment performance. For MIRR calculation, the funds
committed are placed in an account that earns the hurdle rate. The
capital used for investment is carried out of this account, and the
capital distributed goes to this account. MIRR is then calculated by
taking the amount at liquidation and dividing it by the capital
committed, with adjustments for duration. MIRR essentially solves
the problem of funds being helped or punished unfairly by the IRR
reinvestment assumption.
Keywords: Performance Measurement and Evaluation: performance measure-
ment; Performance Measurement and Evaluation: performance attribution; Alternative
Investments: private equity