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? You cannot get it by averaging the two headlines, and you cannot get it from the headlines at all. It comes from the combined dated cash flows. Larger cash flows generally have more influence on that result, but the actual influence depends on when each flow occurs.
You need three compounding conventions for alternative investments.
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.
- Set annual periods: [2ND] [P/Y] 1 [ENTER], down, verify C/Y = 1, then [2ND] [QUIT]
- Clear: [2ND] [QUIT] then [2ND] [CLR TVM]
- Enter: 3 [N], 6 [I/Y], -10000 [PV]
- Solve: [CPT] [FV] -> 11,910.16
Common mistakes
- Confusing DPI and RVPI. DPI measures realized value (distributions received). RVPI measures unrealized value (remaining NAV). Reversing them is a calculation error. A fund with $60M distributions and $50M NAV on $80M invested has DPI = 0.75x and RVPI = 0.625x. If you swap them, you report 0.625x as DPI, which is actually the RVPI.
- 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. Compounding at 10% instead of 6% produces $2,997,400, which applies the wrong reinvestment rate.
- 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, and the sign-change count is a maximum, not the actual number.
- Portfolio IRR comes from the combined dated cash flows, is not a value-weighted average of constituent IRRs, and can fall outside the range of the inputs; size and duration both drive economic value.
- 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, calculate TVPI as DPI + RVPI. For MIRR, remember: "Reinvest forward at RR, finance backward at CC, raise to 1/T." Positive cash flows compound forward at the reinvestment rate. Negative cash flows discount back at the financing rate. T is years between first and last cash flow. If you mix the rates or miscount T, you get a wrong MIRR.
The full lesson (about 6,552 words, 44 min read) adds 2 worked examples, all 8 common mistakes, a self-check, free in the app.
Learning objectives
- defining alts
- blurred lines
- risk return characteristics
- goals
- history us
- history asia
- 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
- binomial trees
- single-factor default-free bond models
- reduced-form modeling credit risk
- single-factor equity pricing models
- single factor models
- hypothesis testing
- sampling problems
- forwards vs futures
- forward foundations
- forwards on rates
- carry forwards
- managing long short
- option exposures
- rate options
- option pricing
- risk measures
- var
- benchmarking
- ratio measures
- risk adjusted
- estimating alpha
- pricing data
- appraisals smoothing
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