A private equity fund reports a 25% IRR. Sounds great. But the fund invested only $10 million over five years, while a second fund earned 15% on $200 million. The combined portfolio IRR? Just 16.2%. That headline number lied about where the money actually went.
You need three compounding conventions for alternative investments. Each shows up differently on the exam.
Annual compounding uses the formula:
FV = PV x (1 + r)^n
If you invest $10,000 at 6% for three years, you get $10,000 x 1.06^3 = $11,910.16. Simple interest would give you $11,800. The difference is interest earned on prior interest.
- Clear: [2ND] [QUIT] then [2ND] [CLR TVM]
- Enter: 3 [N], 6 [I/Y], -10000 [PV]
- Solve: [CPT] [FV] -> 11,910.16
Periodic compounding splits the year into m periods. The effective annual rate is:
EAR = (1 + r/m)^m - 1
At 12% nominal with quarterly compounding, the periodic rate is 3%. The EAR = 1.03^4 - 1 = 12.55%. With semi-annual compounding, EAR = 1.06^2 - 1 = 12.36%.
Common mistakes
- Confusing DPI and RVPI. DPI measures realized value (distributions received). RVPI measures unrealized value (remaining NAV). The exam reverses them in the answer choices. A fund with $60M distributions and $50M NAV on $80M invested has DPI = 0.75x and RVPI = 0.625x.
- Using the financing rate to compound inflows in MIRR. The reinvestment rate (RR) compounds positive cash flows forward. The financing rate (CC) discounts negative cash flows back. Mixing them up changes the terminal value. At 10% instead of 6%, the terminal value becomes approximately $2,997,000, an answer choice designed to catch this mistake.
- Plugging the wrong T into MIRR. T is the number of years between the first and last cash flow, not the count of nonzero cash flows. A 4-year project with cash flows at t = 0, 1, 2, 3, 4 uses T = 4, not T = 5.
Bottom line
- IRR assumes all interim cash flows are reinvested at the IRR itself, an assumption that is often unrealistic and more distorting the higher the IRR.
- A complex cash flow pattern is either a borrowing-type stream (inflows first, outflows later) or a multiple sign change stream; only the latter can yield multiple IRRs.
- Portfolio IRR is not a value-weighted average of constituent IRRs and can even fall outside the range of the individual inputs.
- MIRR uses an explicit reinvestment rate (RR) and cost of capital (CC), with T = years between the first and last cash flow; negative cash flows enter as absolute values.
Exam shortcut
When you see a TVPI question, check whether it equals DPI + RVPI. If the answer choices include both the DPI and RVPI individually, one of them is the trap, the exam expects you to add them, not pick one. For MIRR, remember: "Reinvest forward at RR, finance backward at CC, raise to 1/T." Positive cash flows compound forward at the reinvestment rate.
The full lesson (about 4,912 words, 33 min read) adds 2 worked examples, all 8 common mistakes, a self-check, free in the app.
Learning objectives
- defining alts
- blurred lines
- history us
- history asia
- risk return characteristics
- goals
- buy sell side
- service providers
- legal structures
- fund types
- fund features
- fund terms
- drawdown fees
- waterfall calcs
- hedge fund fees
- fees and behavior
- return math
- irr
- irr problems
- modified irr
- other measures
- j curve
- notional principal
- return distributions
- moments
- covariance correlation
- beta autocorrelation
- std dev variance
- normality testing
- market efficiency
- time value
- forward rates
- arbitrage
- binomial trees
- single factor models
- hypothesis testing
- sampling problems
- forwards vs futures
- forward foundations
- forwards on rates
- carry forwards
- managing long short
- option exposures
- rate options
- rate swaps
- option pricing
- risk measures
- var
- benchmarking
- ratio measures
- risk adjusted
- pricing data
- appraisals smoothing
- alpha beta overview
- estimating alpha
- return attribution
- statistical issues
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