IRR, or internal rate of return, is one of the most common metrics for measuring private equity performance, as well as general investment performance. If you’ve ever spent time looking at private equity fund returns, you may have come across gross IRR vs. net IRR metrics. It’s an important distinction to understand and can have a huge impact on performance evaluation.
What is the Difference?
Gross IRR is the investment’s rate of return prior to any fees or costs. Net IRR is the rate of return after accounting for any fees or costs incurred.
As such, gross IRR will always be higher than net IRR. From that, gross returns will be the returns at the fund level, while net IRR will be returns to outside investors participating in the fund.
When used in the context of private equity, these expenses relate to management fees, fund expenses, and carried interest. At the most basic level, this typically takes the form of ‘2-and-20’, or a 2% management fee on invested capital and a 20% performance fee on fund profits.
Different funds will have different fee structures with varying percentages, or potentially incorporating concepts like returns hurdles. In a scenario with returns hurdles, the fund and its General Partners will not participate in the performance fee until a specific benchmark is met. For example, this could take the form of 1.5x MOIC.
Why Does it Matter?
It’s a simple concept, but you need to make sure that you are looking at apples to apples metrics when comparing returns. Given that gross IRR is prior to expenses, all else equal, it will show a greater return than net IRR, which can distort your analysis if you’re not careful.
Gross IRR and Net IRR are commonly used by LPs to make capital allocation decisions. This could be across asset classes (public markets vs. private equity vs. real estate), for example. Or, it could be across funds within an asset class (e.g. Blackstone vs. KKR). As an investor, you obviously want to get the highest return possible.
A Simple Example
In a simplified example, consider two private equity firms that are raising new funds. They reach out to LPs to get capital commitments, marketing the potential investment based on the performance of their current and prior funds.
Firm A has a historical Gross IRR of 25%, while Firm B has a Gross IRR of 20%. At first glance, Firm A clearly looks like the better place to park your money. However, taking a look at the firms’ historical Net IRRs shows Firm A at 15% and Firm B at 18%. Now you would obviously prefer to allocate your money to Firm B, all else equal.
With that example, it makes sense that private equity LPs (limited partners) care most about net IRR. That’s because this constitutes the real returns they’ll receive from the fund. On the flip side, if you’re evaluating job offers between different private equity firms, you likely care more about gross IRR. This gives the cleanest picture of actual investment performance, and the bigger the difference between gross IRR and net IRR, the greater the share of economics for that firm and fund.
… And a More Detailed Example
Here’s a summary of gross vs. net IRR in Excel with annual cash flows. In the gross IRR example, you have an initial $100M investment, then receive $250M in returns at the end of the hold period. Pretty simple.
Now we get to the net IRR example. Here we have the same $100M investment in the first period.
We also have a 2% annual management fee paid to the private equity sponsor. This fee is based on the initial capital deployed (the $100M).
Next, we have $100k in annual fund expenses.
Finally, we also take out the carried interest, or share of profits held by the private equity fund. In this example, the carried interest is 20% of the $150M profit ($250M exit proceeds less the $100M initial investment).
As you can see, the exact same deal has a hugely different return for the investor after you account for fees. In this case, the net IRR is a full 5% lower than the gross IRR. This is on the higher end of the typical range of variance, but illustrates the importance of the concept.
How Big of a Difference is There?
While there are no hard and fast rules, a general rule of thumb for gross IRR vs. net IRR is a 10% haircut to Gross IRR. In this scenario, a 20% gross IRR would equate to an 18% net IRR. This method will generally err on the side of overestimating the difference, but is helpful as a quick conservative approach.
Note that the 10% rule is quite a bit smaller than the example used above. This example was hypothetical and used to illustrate the dynamics, so was overstated.
With that, you may be thinking that a 10% difference between gross IRR vs. net IRR is pretty insignificant. However, keep in mind that a 2% decline in your actual rate of return will be hugely meaningful across the portfolio if you’re an LP managing billions of dollars (think pension fund, endowment, etc.).
This dynamic also provides an attractive incentive to employees at private equity firms: fee-free, carry-free co-investment. Senior members of the investment team are often required to personally participate in the fund, while junior members may or may not be given the opportunity. These investments are typically made absent of management and carried interest expenses, so offer the opportunity to capture the higher net IRR.