The Tyranny of IRR

The since-inception internal rate of return (si-IRR) is widely reported by the private equity (PE) industry and interpreted as a meaningful rate of return. Si-IRR does not, however, represent the actual rate at which investor wealth grows over time. Its misuse may have contributed to the widespread belief that private equity significantly outperforms other asset classes, thereby fueling the dramatic rise in capital allocated to PE funds and their increasing presence in retail portfolios. A prominent example is the Yale Model, which advocates heavy allocations to private equity based largely on their reported si-IRR. To counter these misconceptions, regulators and standard-setters should consider prohibiting the use of si-IRRs, mandating the use of horizon IRRs under clearly defined conditions, and renaming si-IRR metrics to avoid the misleading term rate of return (e.g., using internal discount rate instead). Ultimately, although the net present value of an illiquid asset is conceptually sound, a rate of return is not.