While visiting Pier 39 in San Francisco with my family, a street magician made a $20 bill multiply into $100 right before our eyes—a 400% return in seconds! My son was convinced we’d discovered the secret to instant wealth. Walking away, he asked why we don’t just give all our money to magicians.
Many investors must feel this way about private equity returns. The numbers look magical—20%, 25%, even 30% IRRs!—but when they check their account balances years later, the growth feels more like a modest card trick than a grand illusion.
The Tale of Two Returns
Here’s the uncomfortable truth: that impressive IRR (Internal Rate of Return) your private equity fund is showing tells a very different story than the actual growth of your wealth (TWR, Time-weighted Return).
It is not deception—it is simply math, and the difference can be shocking.
It is not a new problem. According to research from the CFA Institute, some venture funds from the late 1990s boasted high IRRs that significantly overstated long-term performance. When investors calculated their actual wealth growth, the time-weighted returns were often less than half the advertised IRR. It was still respectable, but not quite the rabbit-from-a-hat performance they expected.
Why the Magic Trick Works
IRR is like measuring the speed of a race car only when it’s on the track, ignoring all the time it spends in the pit stop. It calculates returns based on when money is actually invested, not when you committed it. In other words, IRR is a money-weighted return that “measures the rate of return earned on the actual money invested, taking into account when those cash flows occur.”
Here’s how the illusion unfolds:
The J-Curve Sleight of Hand: Most private equity funds exhibit what industry experts call a “J-curve”: negative returns early (due to fees and initial investments) followed by gains later. Imagine you commit $1 million to a fund.
Year 1: They call $100,000, and it drops 10% (fees, early investments).
Your IRR? Negative 10%.
Year 5: They invest the remaining $900,000 in a home run deal that doubles. Your IRR might show 25%, but your actual money grew much less because most of it sat idle for years.
The Quick Flip Trick: A fund buys a company for $50 million, fixes it up, and sells it for $75 million in 18 months. The IRR? A dazzling 30%! The multiple? Just 1.5x. You made 50% total over 18 months, but not 30% per year. It’s like our magician turning $20 into $30—impressive speed, modest outcome.
The Credit Line Illusion: Today funds commonly use a clever trick: borrowing money to make investments before calling on your capital. This shortens the “official” investment period, artificially boosting IRR. Industry research shows this practice can inflate IRRs by roughly 2 percentage points (up to 3% with aggressive use) without creating additional wealth. It’s the same deals and outcomes, just with different cash flow timing.
The Gross vs Net Shell Game: Many investors miss—when a fund advertises a 25% IRR, is that gross or net? The difference is massive. Gross IRR is before fees; net IRR is what you actually get after management fees (typically 2% annually) and carried interest (usually 20% of profits). That advertised 25% gross IRR may translate to just 18-19% net IRR for investors. And remember, we already established that a 20% IRR might only grow your wealth at 12-13% annually.
So that headline 25% gross IRR could mean your money actually compounds at closer to 10% per year—less than half what the number suggests.
The Fund vs Investor IRR Gap: Here’s the final layer of misdirection: even that net IRR isn’t YOUR actual return. The IRR of the fund is calculated on their cashflows (investment activity), where as the investor’s cashflows are driven by wire transfers made to meet capital calls and distributions received on the bank account. The rates of return will diverge—sometimes by a few basis points and sometimes by several hundred.
The Reality Check: What You Actually Experience
When investors measure their actual wealth growth (Time-Weighted Returns or TWR), the numbers tell a sobering story. According to comprehensive industry studies:
- Median private equity IRRs: 14-18%
- Actual average wealth multiples achieved: ~1.7x over 10 years
- Implied annual wealth growth: ~5-7%
As J.P. Morgan Asset Management points out, “the net IRR of a single fund can be ~1.5–1.7 times the net TWR that delivers a similar outcome over 10 years.” That’s right—your 15% IRR fund might only be growing your committed capital at 9-10% annually when you factor in the timing of cash flows.
Managing the Expectation Gap
So, how do we bridge this gap between marketed returns and actual experience?
- Always ask for NET IRR, not gross. The typical “2 and 20” fee structure can reduce returns by 5-7 percentage points
- Always ask for the multiple (net MOIC, TVPI, DPI) alongside the IRR. Remember: IRR rewards speed, not scale. A quick small gain can produce astronomical IRRs.
- Advanced: Request PME (Public Market Equivalent) analysis against relevant benchmarks. If a fund claims to beat the S&P 500, ask for the S&P’s IRR using the same cash flow pattern.
Translation Guide (based on typical deployment patterns):
- 20% net IRR ≈ net 12-13% annual wealth growth
- 15% net IRR ≈ net 9-10% annual wealth growth
- 10% net IRR ≈ net 6-7% annual wealth growth
Making Peace with the Magic
Walking away from that street performer at Pier 39, I explained to my son that the magician’s trick was entertainment, not an investment strategy. Private equity IRRs are similar—they are real calculations that measure something specific: how efficiently capital was deployed when it was deployed. But like our magician’s trick, they don’t tell the whole story of wealth creation.
The solution isn’t to avoid private markets—they can deliver solid returns and diversification. It is to understand what you are really buying: typically 1.5-2x your money over 7-10 years, not the compound interest miracle that IRR figures might suggest.
Sources:
- CFA Institute (Ludovic Phalippou), Nov 8, 2024, “The Tyranny of IRR: A Reality Check on Private Market Returns“
- Cambridge Associates, Andrea Auerbach, Jun-2018, “Should You Avoid Commitment (Facilities)?”
- Cambridge Associates, Jill Shaw, May 2014, “A Framework for Benchmarking Private Investments
- “J.P. Morgan Asset Management Q1 2025, “A Guide to Alternative Fund Returns“
