Gross IRR vs Net IRR

Internal Rate of Return (IRR) is the default performance reporting metric for many private market assets, from real estate to private equity and venture capital. Unfortunately, IRR is complex to calculate and not an intuitive metric for most investors, so calculators/spreadsheets are a must to determine and compare both gross IRR and net IRR.

Nearly all investments incur expenses and so there is a difference between gross and net performance. Gross IRR does not include expenses and represents performance before expenses, while net IRR includes expenses and thus represents performance after expenses. Investors evaluating any type of performance should compare gross vs net performance, including gross IRR vs net IRR.

Gross IRR

Technically, IRR is the discount rate one would need to use so that the net present value (NPV) of all future cash flows is zero. Gross IRR considers the cash flows before the deduction of expenses, so the cash flow inputs and resulting IRR are higher than with net IRR.

Gross IRR Calculation & Example

The IRR calculation is complex, but a calculator can do it relatively quickly. If I’m in rush or want to get a ballpark estimate, I’ll simply google “IRR calculator.” Microsoft Excel and Google Sheets also have IRR (if periodic cashflows) and XIRR (if non-periodic cashflows) functions.

Using an online calculator, Excel, or Sheets, we can input the below cash flows and determine that the IRR is 17.5%.

Initial Investment$100,000
Year 1 Cash Flow$10,000
Year 2 Cash Flow$20,000
Year 3 Cash Flow (final distribution)$125,000
IRR17.5%
Source: ThoughtfulFinance.com

Net IRR

As stated above, IRR is the discount rate one would need to use so that the net present value (NPV) of all future cash flows is zero. Net IRR considers the cash flows after the deduction of expenses, so the cash flow inputs and resulting IRR are lower than with gross IRR.

Net IRR Calculation & Example

As mentioned above, the IRR calculation is complex, but a calculator can do it relatively quickly. If I’m in rush or want to get a ballpark estimate, I’ll simply google “IRR calculator.” Microsoft Excel and Google Sheets also have IRR (if periodic cashflows) and XIRR (if non-periodic cashflows) functions.

The main difference when calculating net IRR vs gross IRR is that we’ll have to adjust the amounts of the cashflows. In the below example, we will add a 10% performance fee (carry/promote/incentive) to the cash flows of the above example. Therefore, the cash flows will only be 90% of the cash flows in the gross IRR example above.

Using an online calculator, Excel, or Sheets, we can input the below cash flows and determine that the IRR is 13%.

Initial Investment$100,000
Year 1 Cash Flow$9,000
Year 2 Cash Flow$18,000
Year 3 Cash Flow (final distribution)$112,500
IRR13.0%
Source: ThoughtfulFinance.com

Gross vs Net IRR: Calculation Differences

As the above examples show, the main difference between gross IRR vs net IRR calculations is the impact of expenses on the cash flow inputs used in the calculation. The calculation remains the same, but the inputs need to be adjusted beforehand. Common adjustments include:

  • Upfront or one-time fees at the fund level
  • Upfront or one-time fees at the asset level
  • Expenses (such as legal, accounting, audit, etc.)
  • Management fees
  • Performance fees (carry, promote, incentive, etc.)
  • Exit/disposition fees

There may be others, but these are the ones that I observe most frequently.

Gross vs Net IRR in Private Equity

Although IRR is a common reporting metric, there is variation in how it’s reported. Some default to reporting gross IRR, while others default to net IRR.

The most common practice seems to be reporting net IRR at the fund level. All fund expenses and investor-level fees are deducted, with the caveat that the performance of any single investor will vary.

There are a few reasons that investor-level returns deviate from fund -level returns. Different investors often pay different fees (and reporting a multitude of individualized net IRRs is not feasible). Early investors often receive discounts and larger investors qualify for fee breakpoints.

Reporting an investor -level IRR is further complicated by the fact that investors may have invested at different points in time. Even if there are equalization terms and catch-up interest is paid, there are timing differences that could impact an investors IRR. Additionally, it is not uncommon for equalization to adjust the equity or NAV for investors, but allow early investors to keep the income distributions that they already received.

Some sponsors report gross IRR and some may report IRR that is net of non-fee expenses and gross of fees. Still others might report non-IRR performance metrics like MOIC or TVPI or not report anything at all! Even if IRR is reported though, it is important that investors understand if it is gross IRR, net IRR, or some hybrid IRR, as well as how it is derived.

Roth IRA vs Mutual Funds

An interesting question that I’ve heard in the past is “Should I invest in a Roth IRA or mutual funds?”

It’s an interesting question because Roth IRAs and mutual funds are two completely different types of things and not comparable at all. Read on to learn about the differences of Roth IRA vs Mutual Funds.

The short answer is that a Roth IRA is a type of account and a mutual fund is a type of investment (which can be held inside a Roth IRA).

To use the above image as an analogy, one could think of the ship as a Roth IRA and the containers as mutual funds. One can put anything on a ship, including containers full of things. Or they can fill the ship up with items not in containers. But nobody would use ships and containers interchangeably. A longer answer is below.

Roth IRA

Roth IRA is a type of retirement account (we’ll technically, it’s an Individual Retirement Arrangement according to the IRS). Investors can own just about anything within an IRA. For example, many investors own mutual funds inside an Roth IRA.

Mutual Funds

Mutual funds are a type of investment product/vehicle. Mutual funds are essentially a portfolio of assets (such as stocks or bonds or other assets) that issue shares to investors. So a mutual fund may own billions of dollars of stocks and I can purchase a fractional share of that portfolio and participate in the investment performance of the mutual fund.

Roth IRA vs Mutual Funds

The question of Roth IRA vs mutual funds may be the result of confusion or misunderstanding.

One reason for confusion is that some salespeople who pitch a certain product may imply that a Roth IRA is the product. For instance, banks may pitch a CD as a Roth IRA CD. The truth is that it would be a CD registered/titled as a Roth IRA. In other words, Roth IRA would be the account type rather than the investment vehicle. In my experience, sometimes the people selling various financial products do not even understand the basics unfortunately.

Another cause for confusion is simply that people are new to investing and confused about the words and terminology. That’s why this blog exists, to help people even when questions are very simple.

Assets Under Management vs Private Equity

A question that sometimes comes up is: Assets Under Management vs Private Equity. Its not a straightforward question or comparison because its like comparing apples to… boats. My suspicion is that those asking about private equity vs assets under management are either new to the space or perhaps confusing terms. Below are brief definitions of assets under management and private equity, as well as some alternative (and likelier) questions.

What is Assets Under Management?

Assets under management is usually abbreviated as AUM and refers to the value of assets that an “asset manager” manages. For instance, I can google “Vanguard AUM” and see that Vanguard manages roughly $7T of assets. This includes the total value of their mutual funds, exchange-traded funds (ETFs), separately managed accounts (SMAs), and so on, all of which are owned by “asset owners” such as individuals, pensions, and so on.

What is Private Equity?

Private equity is a type of asset management. Private equity refers to investing in assets that are not publicly traded. If a business has stock listed and traded on an exchange then it is public equity; if the business’ shares are not traded publicly then it is private equity. Private equity can include anything from a small mom-and-pop business to a large international corporation.

Assets Under Management vs Private Equity

Based on the above definitions, it is apparent that assets under management and private equity are not really comparable terms. Below are some ideas about what some might mean when they ask about assets under management vs private equity:

Asset Management vs Private Equity

Asset management is an expansive term that refers to managing investments on behalf of asset owners. Private equity is a type of asset management and so it is a subset of asset management. Perhaps questioners are confused between asset management and assets under management.

Assets Under Management of Private Equity

Another possibility is that questioners are wondering about the AUM of private equity. The answer depends on whether the question refers to all private equity, private equity funds, a certain sponsor’s private equity funds, etc.