What Does IRR Mean in Private Equity?
A fairly simple term, but one which is often misunderstood. Here, we explain what the Internal Rate of Return actually is.
- Internal rate of return (IRR) measures the annualized growth rate of an investment in a private equity fund, based on its actual or expected cash flows
The Internal Rate of Return (IRR) is the discount rate at which the net present value (NPV) of all cash flows from an investment equals zero. In plain terms, it is the annualized rate of growth at which money invested in a fund compounds over time, taking into account precisely when capital was committed and when returns were received.
The formula works backward from the outcome. If a private equity fund invests $100m today and returns $250m in five years, the IRR is approximately 20 percent. But if the same $250m comes back after eight years, the IRR falls to around 12 percent. Same absolute return, very different compound growth rate — and that gap is exactly what IRR is designed to capture.
This sensitivity to timing is IRR’s defining characteristic. Unlike MOIC (multiple-on-invested-capital), which simply divides what came out by what went in, IRR rewards funds that return capital quickly and penalizes those that hold assets for longer than planned. A fund that realizes strong exits in year three will show a higher IRR than one achieving the same total value by year seven, even if both end up at the same MOIC.
How IRR connects to carried interest and the hurdle rate
IRR is also the mechanism that determines whether fund managers receive their share of any gains. Every PE fund is structured around a hurdle rate: the minimum annualized return that limited partners (LPs) must receive before the general partner (GP) can take carried interest — typically 20 percent of profits above that threshold. A hurdle rate of around 7–8 percent is common in private equity agreements, and it is cumulative and compounded annually, meaning the fund must consistently outperform this level over its entire life, not just in a single year.
The relationship is straightforward: if a fund’s net IRR exceeds the hurdle rate, the GP earns carry on the excess. If it does not, the investor keeps all the returns. This structure is central to how private equity aligns the interests of managers and investors. A GP cannot reach into the carry pot on the strength of early paper gains as the clock is always running, and the hurdle compounds.
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