So I'm wondering which way PE firms calculate fund returns:
Say fund is \$5b, 7 year horizon, they do 3 deals and invest the 5, sell 1 company at year 4, sell another company at year 6, sell the last deal at year 7. They return 25% on the first 2b investment sold at yr 4, 20% on the next 2b investment sold at yr 6, and 12% on the last deal sold at year 7.

Do they calculate the IRR as the money-weighted IRR each deal that was exited? (So \$2b buyout sold year 4 at 25% annual became \$4.9b, \$2b buyout at 20% sold year 6 became \$5.9b, and 3rd investment of \$1b sold year 7 at 15% became \$2.6b.) Do they ascribe 40%, 40% and 20% to those IRRs? Or do they assume the first two deals money that was returned was reinvested at 25% and 20% respectively, and skew the data to make the funds IRR look higher than it is.

I know that they do that for returns since inception. Where a firm has a vintage fund that performed at 40%, and in the accounting they assume those funds were reinvested at that rate permanently, so the firms since inception IRR will almost never change.

Yeah so I'm just trying to get clarity on whether the reported numbers are manipulated or solid and how they're done, because lord knows finance is full of goofy ways of accounting that make things look better

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Always interesting to get into the nitty gritty of these things. The comments below are for a whole of fund waterfall.

For fund levels returns IRRs, all cash flows into the fund (purchase price for investments, management fees and partnership expenses) and out of the fund (proceeds from sale of companies, dividend recaps etc) can be lined up and the latest NAV of remaining value of assets can be used to calculate IRR.

As you suspected, this can be "gamed" through a) early exits have an anchoring effect on IRR and b) use of subscription lines (where the fund borrows to fund the purchase of companies and call capital from LPs later) juices the IRR.

For individual asset returns, cash flows at just that company level will be used but really represent exit value or NAV divided by purchase price (ignoring interim cash flows for simplicity). So management fees or performance fees wouldn't be taken into account.

Also, unless the fund is able to recycle proceeds from a exit to make up for the fees charged, the fund would unlikely invest the full \$5bn into the 3 companies in your example.

These calculations always come with footnotes and this is why you need to look at IRR along with other metrics (i.e. MOIC, cash yield, etc.).

Of course, but moic is only as good as its related to it's time frame. A true IRR is a great metric. But the gaming of IRRs in PE seems absurd, and this is absolutely the metric that is most used for marketing and citing performance. Ask about PE returns or watch someone interviewed about them and IRR is the metric that will be quoted.

Does investor capital still get charged 2% management fee even when it hasn't been drawn down because they used subscription lines? Because juicing IRR would seem like a silly tradeoff if it comes at the cost of not collecting those fees (unless its a first fund and you need to have a sick IRR for marketing purposes)

Fees are still collected but can be collected from the subscription line (from the sub lines I have seen). This defers the capital call to LPs.

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