INVESTMENT RISK AND PERFORMANCE

by YINDENG JIANG, CFA

New Money-Weighted Return on Illiquid

Investments: A Simple Formula to Replace IRR
Internal rate of return (IRR) is widely used as a measure of money-weighted return
(MWR) to evaluate the performance of illiquid investments. Unfortunately, IRR has
many documented deficiencies, most of which are not broadly known to practitioners.
Some of those deficiencies are reviewed here, and the article also shows that IRR is
fundamentally not an MWR. Also presented is a new measure of MWR based on the
notion of aggregate income divided by aggregate capital. The new measure is easy
to calculate and free from any of the deficiencies of IRR, so it should play the role IRR
has been playing in performance measurement.

INTRODUCTION
The popular internal rate of return (IRR) measure is one of
the few metrics available for measuring the rate of return
on investments in cases where frequent market values are
not available, such as private equity, venture capital, and
private real assets investments. Although a large body of
literature has long documented various issues with the
IRR approachsuch as problems with multiple IRRs
or nonexistent IRRs1IRR is often implicitly assumed
to provide a good measure of money-weighted return
(MWR) that takes into account the impact of cash flows.
A recent study by Magni (2010) points out a fundamental
flaw with using IRR and argues that the measure is not
the correct rate of return even when it is unique.
This article shows that, contrary to conventional wisdom, IRR is actually not a money-weighted return. It is
perhaps more accurately described as a money-sensitive
return, one that approximates a money-weighted return.
This conclusion should not be too surprising because, after
all, how money weighting works in the calculation of IRR
is not clear.
Despite the issues with IRR, the research efforts
devoted to finding an appropriate measure of excess
return on illiquid investments relative to a public market benchmarkthe so-called public market equivalent
(PME) analysishave focused largely on IRR-based

approaches (see Long and Nickels 1996; Rouvinez 2003;

Cambridge Associates 2013; and Gredil, Griffiths, and
Stucke 2014). Therefore, although the PME methods have
evolved considerably over time, they are still subject to the
same issues that affect IRR. Kaplan and Schoar (2005)
introduced a PME measure that does not use IRR, and
Sorensen and Jagannathan (2015) recently showed that
it is justifiable using Rubinsteins (1976) dynamic version
of the CAPM, but it is not a measure of the rate of excess
return. Also, apparently, there is a missing link between
the IRR literature and the PME literature, in that they
are both trying to solve the same problem because PME
is simply IRR with a variable cost of capital.
When the result of Magni (2010) is generalized to
continuously compounded returns (log returns), a new
and simple method is obtained that directly measures the
rate of excess return on illiquid investments relative to a
benchmark. This rate is referred to here as the moneyweighted excess return (MWER). Free from any of the
deficiencies of IRR, MWER has a closed-form formula,
is computationally simple, and yields a solution that is
always unique and economically significant. In particular,
MWER can handle cash flows that have multiple changes
in sign just as easily as those with a single change in sign.
As pointed out previously, MWER also provides a direct
answer to the PME problem because it allows a variable
2016 CFA INSTITUTE. ALL RIGHTS RESERVED. 1

cost of capital. Moreover, MWER is the first cash-flowbased method of calculating return that accounts for the
structure of cash flowsthat is, the same cash flow stream
but with different structures can potentially yield different
rates of return. As an example, if an investments market
value is known at a specific point before the end of the
investment (which does not affect its cash flow stream),
its rate of return may be different from the investment if
no market values are available.

FUNDAMENTAL ISSUES WITH IRR

As argued by Altshuler and Magni (2012), IRR internally devises its own implied sequence of interim capital
values for which it is a rate of return. This sequence of
interim capital values is a convenient mathematical construct but has little economic significance. In a sense, the
problems with multiple IRRs or nonexistent IRRs are
essentially symptoms of this fundamental flaw because
the interim capital values cannot be determined a priori.
Consequently, an approach that merely tries to circumvent
those problems is probably treating the symptom rather
than the cause.
Multiple IRRs often occur for private investment
funds with investment periods that last multiple years, during which they may make distributions while continuing
to call for capital for new investments, resulting in cash
flow streams that have several changes in sign. Consider
the cash flow stream (100, 390, 503, 214.5) discussed by
Magni (2013), which has the following three IRRs: 10%,
30%, and 50%. Which one is the correct, or relevant, rate
of return for an investor?
An implication of the fundamental flaw with IRR
is that, contrary to conventional wisdom, IRR is actually
not an MWR. This claim will be proved with a simple
numerical counter-example and some first principles
of MWRs. By definition, if IRR is an MWR, the IRR
of a portfolio of two investments, A and B, should be a
money- (or capital-) weighted average of As IRR and
Bs IRR:
IRR ( A + B) =

c ( A)

c ( A) + c (B)

IRR ( A) +

c (B)

c ( A) + c (B)

IRR (B),

where c(X) is the capital of X.

To appropriately define money or capital is a challenging task because of the time value of money, and it
is addressed later in this article, but no exact definition is
needed for the present purpose. Any definition of capital

2 WWW.CFAINSTITUTE.ORG

should have two basic properties: (1) it should be additive [i.e., c(A + B) = c(A) + c(B)] and (2) it should be scale
invariant [i.e., c(A) = c(A) for any scaling factor ]. Now,
consider the following two cash flow streams:
A : (100,150),

B : (100, 0,121),
so As IRR is 50%, Bs IRR is 10%, and the IRR for A + B
(200, 150, 121) is 23.85%. Some simple algebra produces
c ( A)
c (B)

IRR ( A + B) IRR (B)

IRR ( A) IRR ( A + B)

Substituting in the IRRs obtained yields

c ( A)
c (B)

23.85% 10%
= 0.53.
50% 23.85%

Now, consider the property of scaling: Scale up A by a

factor of 2, so As cash flow stream becomes (200, 300),
which has the same IRR of 50% as before. and the cash
flow stream of A + B is (300, 300, 121), which has a
unique IRR of 30.83%. Therefore,
c (2 A)
c (B)

30.83% 10%
50% 30.83%

= 1.09 1.06
=

2c ( A)
c (B)

This conclusion contradicts the scale invariant property of

money or capital. Hence, IRR is not an MWR.
Finally, IRR ignores the structure of cash flows, which
may contain important information about the rate of
return. Because IRR depends only on netted or aggregated cash flows, it implies that knowing the cash flows
of the portfolios underlying company investments is as
good as knowing the aggregated cash flows of the fund,
in terms of determining the fund return. Underlying cash
flows, however, may provide information about the fund
return beyond what is provided by the aggregated cash
flows. As an extreme case, suppose a private equity fund
invests $10 in Company A in Year 0 and sells it for $30
in Year 1. Then, the fund invests $25 in Company B in
Year 3 and sells it for $0 in Year 4 (i.e., it is a total loss).
Clearly, Company As cash flow stream (10, 30) has a
unique return of 200%, and Company Bs cash flow stream
(0, 0, 25, 0) has a unique return of 100%, so the funds

return must be somewhere between 200% and 100%. The

aggregated, fund-level cash flow stream (10, 30, 25, 0)
has no real-valued IRR.
Therefore, valuable information is lost when cash flow
streams are aggregated, which implies that any valid metric
of MWR should take into account underlying cash flow
streams if they are known.

NEW MONEY-WEIGHTED RETURN FORMULA

For the exact methodology of the new MWR, the interested reader may consult the full paper ( Jiang 2015) . The
basic concepts are outlined here.
Given the importance of underlying cash flow
streams, first, a three-step process is used to decompose any investment/cash flow stream into what can be
referred to as indivisible cash flow streams. In the current context, such indivisible cash flow streams would
typically correspond to a portfolios company investment
but could be a smaller unit if the company itself can be
conceptually treated as a combination of individual cash
flow streams.
For each indivisible cash flow stream, its aggregate
excess income and aggregate capital are calculated via the
discounted cash flows obtained by using the benchmark
rates. The aggregate excess income is simply the wellknown net present value (NPV); the aggregate capital is
calculated as the sum of each cash flows impact on capital.
Finally, the aggregate excess income for the investment
in question is the sum of all aggregate excess incomes of
the underlying indivisible cash flow streams, and a similar
summing is done for the aggregate capital. The MWER on
the investment is given by the ratio between its aggregate
excess income and aggregate capital.
This three-step decomposition process ensures that
the aggregate capital at any level is always nonnegative,
which implies that the MWER is of the same sign as the
aggregate excess income or NPV; that is, a positive NPV
always leads to a positive MWER and a negative NPV
always leads to negative MWER. The preservation of sign
between NPV and MWER is important for the practical
interpretation of MWER as a rate of excess return. For
example, for the NPV to be positive, it would make practical sense only if the excess return is also positive.

EXAMPLE
The calculation of MWER can be illustrated with a stylized example.

Consider the cash flow stream f = (100, 390, 503,

214.5) as discussed previously. It has the following three
IRRs: 10%, 30%, and 50%. For simplicity, assume the
benchmark return is zero. Note that the NPV turns positive after the second cash flow. First, the cash flow stream
must be decomposed into
f1 : (100,390),

f 2 : (0, 0, 503, 214.5).

The aggregate capital for f1 is 100, and the aggregate

capital for f 2 is
0(3 0) 0(3 1) + 503(3 2) = 503,
so the MWER for f is given by
100 + 390 503 + 214.5 1.5
=
100 + 503
603
= 0.25%,
which is unique, computationally simple, and economically
significant. Moreover, it turns out that none of the three
IRRs in the preceding paragraph (10%, 30%, 50%) is the
relevant rate of return.

CONCLUSION
How to measure the relative performance of illiquid
investments is a topic of great importance to industry
practitioners. The wide use of the IRR approach is the
result of both a lack of recognition of the fundamental
difficulties with IRR and the lack of a viable alternative.
The MWER fills this gap and provides a method that is
easy to implement and theoretically sound.
The MWER method reveals that the MWR on an
investment is a function not only of its netted cash flow
stream but also of the structure of the cash flow stream,
including any underlying cash flows and pertinent market
values. This important property of MWRs has so far been
overlooked, largely because IRR depends only on netted
cash flow streams.
This article does not address the important question
of choosing an appropriate benchmark for measuring performance of illiquid investments. Sometimes, the choice
is obvious because of the context, such as the hurdle rate
or the cost of capital, but frequently, the chosen public
market benchmark should adjust for factors such as beta
and other risk exposures. These considerations are best
reserved for a follow-up study.

2016 CFA INSTITUTE. ALL RIGHTS RESERVED. 3

NOTES
1. Magni (2013) lists 18 flaws associated with using IRR.

REFERENCES
Altshuler, Dean, and Carlo Alberto Magni. 2012. Why
IRR Is Not the Rate of Return for Your Investment: Introducing AIRR to the Real Estate Community. Journal of
Real Estate Portfolio Management, vol. 18, no. 2: 219230.
Cambridge Associates. 2013. Private Equity and Venture Capital BenchmarksAn Introduction for Readers
of Quarterly Commentaries.
Gredil, Oleg, Barry E. Griffiths, and Rdiger Stucke.
2014. Benchmarking Private Equity: The Direct Alpha
Method. Working paper (28 February): http://ssrn.com/
abstract=2403521.
Jiang, Yindeng. 2015. The Money Weighted Return on
Illiquid Investments: A Simple Formula Replacing IRR.
Working paper, University of Washington (29 October):
http://ssrn.com/abstract=2600573.
Kaplan, Steven N., and Antoinette Schoar. 2005. Private
Equity Performance: Returns, Persistence, and Capital
Flows. Journal of Finance, vol. 60, no. 4 (August): 17911823.
Long, Austin M., and Craig J. Nickels. 1996. A Private
Investment Benchmark. Presented at the AIMR Conference on Venture Capital Investing (13 February): http://
dns1.alignmentcapital.com/pdfs/research/icm_aimr_
benchmark_1996.pdf.

4 WWW.CFAINSTITUTE.ORG

Magni, Carlo Alberto. 2010. Average Internal Rate of

Return and Investment Decisions: A New Perspective.
Engineering Economist, vol. 55, no. 2: 150180.
Magni, Carlo Alberto. 2013. The Internal Rate of Return
Approach and the AIRR Paradigm: A Refutation and
a Corroboration. Engineering Economist, vol. 58, no. 2:
73111.
Rouvinez, Christophe. 2003. Private Equity Benchmarking with PME+. Venture Capital Journal (August): 3438.
Rubinstein, Mark. 1976. The Strong Case for the Generalized Logarithmic Utility Model as the Premier Model
of Financial Markets. Journal of Finance, vol. 31, no. 2
(May): 551571.
Sorensen, Morten, and Ravi Jagannathan. 2015. The Public Market Equivalent and Private Equity Performance.
Financial Analysts Journal, vol. 71, no. 4 ( July/August):
4350.
Yindeng Jiang, CFA, is a quantitative research analyst at the University of Washington.