Gross IRR
Also written Gross internal rate of return
An AIF's IRR computed on fund-level cash flows before management fees, incentive fees, fund expenses and taxes — the return the portfolio earned, not the return investors kept.
In plain language
The internal rate of return is the rate at which the present value of an investor's cash outflows equals the present value of the inflows. Timing matters: 15% earned over one year is not the same as 15% earned over three.
Gross IRR applies that idea at the fund level. It asks how well the manager's investments performed, and deliberately ignores everything the fund pays along the way — management fees, incentive fees, fund expenses and taxes. Those costs are borne by the fund and allocated to investors pro rata, but Gross IRR leaves them out.
That makes it the right number for judging the portfolio and the wrong number for judging what an investor earned. For that, the workbook uses Net IRR, which is always lower.
How it works
Cash flows used. The workbook says that for Gross IRR the investors' cash outflows are the total capital calls made by the fund, and the inflows are the distributions received from the fund. Fees, expenses and taxes are ignored.
Computing it. With one outflow and one inflow the formula can be solved directly. With irregular flows, use the XIRR function in Excel (=XIRR(values, dates, 0)) or the cash-flow function on a financial calculator.
The workbook's Fund ABC (Example 7) — Rs 50 crore called on 1 January 2019, five-year life, buy-and-hold:
| Inflow on 31 Dec 2023 | Gross IRR | Net IRR | |
|---|---|---|---|
| Best case | Rs 115 crore | 18.13% | 12.98% |
| Worst case | Rs 70 crore | 6.96% | 3.48% |
The gap is 5.15 percentage points (28.4% of Gross IRR) in the best case and 3.48 points (50%) in the worst — fixed costs take a bigger share of a smaller return.
Where else it appears. Box 6.2 notes that GIPS requires calculation methodologies including Gross IRR and Net IRR on a pre-tax basis. Because Fund ABC's IRRs cover the fund's whole life, the workbook says they can also be treated as since-inception IRR and life-time IRR. IRR is reported to SEBI quarterly or monthly.
The formula
Capital called = Distribution ÷ (1 + Gross IRR)^n
Gross IRR = (Distribution ÷ Capital called)^(1/n) − 1
(single call, single distribution, n years)
A worked example
Illustrative figures. Godavari Absolute Return Fund, a close-ended Category III AIF, calls Rs 40 crore on day one and has Rs 56 crore of gross value to hand back after 3 years.
Gross IRR = (56 ÷ 40)^(1/3) − 1
= 1.40^(0.3333) − 1
= 1.1187 − 1 ≈ 11.87%
The factsheet can honestly say the portfolio compounded at about 11.87% a year. What it cannot say is that investors earned 11.87%. Over those three years the fund also paid management fees with GST, yearly expenses, possibly incentive fees, and tax; Net IRR brings every one of those in as an outflow on its actual date.
Check the workbook's own number the same way:
Best case: (115 ÷ 50)^(1/5) − 1 = 2.30^0.2 − 1 = 18.13%
Worst case: ( 70 ÷ 50)^(1/5) − 1 = 1.40^0.2 − 1 = 6.96%
Why NISM asks about it
Chapter 6 (Fees Structure, Fund Performance and Benchmarking), section 6.2.1.1 defines since-inception, gross and net IRR side by side and works Fund ABC through both. Expect: which costs Gross IRR excludes; whether it is measured at fund or investor level; which is higher; why the gap widens in the worst case; and the Fund ABC figures themselves. Box 6.2 on GIPS lists Gross IRR and Net IRR on a pre-tax basis among the required methodologies.
Common exam traps
- Gross IRR is fund level; Net IRR is investor level. Gross ignores management fees, incentive fees, fund expenses and taxes.
- Gross IRR is always the higher of the two in the workbook's framework.
- The workbook is not internally consistent on the inflow. Its definition says the inflow is the net distribution, but Example 7 computes Gross IRR on the Gross Asset Value of Rs 115 crore, not the Rs 102.62 crore distribution. For a numerical question, follow the example: gross value in, gross value out.
- Do not use Gross IRR for alpha. The workbook's CAPM example uses Net IRR because investors bear the fees.
- The proportional gap is 28.4% in the best case and 50% in the worst — the bad year costs more, proportionally.
- Since-inception and life-time describe the period, not gross versus net; a Gross IRR can be since-inception too.
Check yourself
1.Fund ABC reported Gross IRR of 6.96 per cent and Net IRR of 3.48 per cent in its worst-case scenario, against 18.13 per cent and 12.98 per cent in the best case. What does this show?
- a)The absolute reduction is greater in the worst case, at 5.15 percentage points
- b)The proportionate erosion is greater in the worst case, where half the gross return is lost to fixed costs
- c)Net IRR can exceed Gross IRR where the fund pays no incentive fees
- d)Gross IRR and Net IRR converge as returns fall, because expenses scale with performance
Show the answer
Answer: (b) The proportionate erosion is greater in the worst case, where half the gross return is lost to fixed costs
The best case loses 5.15 percentage points, or 28.4 per cent of the gross figure; the worst case loses only 3.48 points but that is 50 per cent of the gross. As the workbook puts it, the decrease in Net IRR can be more in a worst-case scenario, when the Investment Manager is generating average or below average returns, because Net IRR can substantially be below the Gross IRR if the Category III AIF has high fixed costs. Option (d) reverses the logic — the costs are largely fixed and do not shrink with performance, so they consume a larger share of a smaller return.
2.A fund reports a Net IRR of 12.77 per cent with a portfolio beta of 1.3. The 364-day T-bill rate is 5.60 per cent and the benchmark return is 9.25 per cent. The alpha is:
- a)+2.42 per cent
- b)+3.52 per cent
- c)–2.42 per cent
- d)+7.17 per cent
Show the answer
Answer: (a) +2.42 per cent
Expected return under CAPM is E(R) = Rf + β(Rm – Rf) = 5.60% + 1.30 × (9.25% – 5.60%) = 5.60% + 4.745% = 10.35%. Alpha is R – E(R) = 12.77% – 10.35% = +2.42%. Note that Net IRR figures are taken instead of Gross IRR, on the assumption that investors ultimately bear fixed expenses and fees of the fund. Option (b) is the error of ignoring beta and simply subtracting the benchmark return.
3.Which statement about the IRR measures of a Category III AIF is correct?
- a)A since-inception IRR computed for a previous fund that has been liquidated is also known as Life-time IRR, and IRR is reported to SEBI on a quarterly or monthly basis
- b)Gross IRR is calculated at the investor level after deducting fees and taxes, so it is always lower than Net IRR
- c)Net IRR ignores the timing of cash flows and is therefore a simple average return
- d)Consolidated IRR is the IRR of the single best-performing scheme managed by the Investment Manager
Show the answer
Answer: (a) A since-inception IRR computed for a previous fund that has been liquidated is also known as Life-time IRR, and IRR is reported to SEBI on a quarterly or monthly basis
Since-inception IRR uses the cash flows from the launch date to the reporting date, and ‘If the IRR is being computed for a previous fund which was liquidated, it is also known as Life-time IRR’. The workbook also says ‘The IRR metric is to be reported to SEBI on a quarterly or monthly basis by a Category III AIF’.
- The option on Gross IRR has the definitions reversed. Gross IRR is computed at the fund level, before deducting management fees, incentive fees, fund expenses and taxes. Net IRR is at the investor level, and ‘Net IRR will be lower than the Gross IRR’.
- IRR is built on timing: ‘The timing of the cash flow is important in IRR’.
- Consolidated IRR is calculated ‘by aggregating the cash inflows and cash outflows of all the Category III AIFs, managed by the Investment Manager’ — not from one scheme.
Where this is taught
Free preparation for NISM Series XIX-BRelated terms
- XIRRExtended Internal Rate of Return: the annualised return on an investment with irregular cash flows, found by assigning a date to each flow. PMS reports it for each investor’s own experience.
- AlphaThe return a fund earned above what its beta and the benchmark say it should have earned — the slice of performance left over once the market has been given credit for its share.
- Money Weighted Rate of ReturnThe internal rate of return on an investor's actual cash flows into and out of a portfolio — so it rewards or punishes the timing of those flows, not just the manager's skill.
- GIPSGlobal Investment Performance Standards — voluntary ethical standards, owned by CFA Institute, for calculating and presenting investment performance on the principles of fair representation and full disclosure.
- Incentive FeesThe Category III AIF manager's share of profits — a percentage of the return above both the reference hurdle and the high-water mark, set out in the PPM and borne pro rata by all investors.
- Management FeeThe fixed annual fee an AIF pays its investment manager for managing the fund — charged on committed capital in Category I and II funds and on gross NAV in Category III, regardless of performance.
- Net IRRAn AIF's IRR measured at the investor level, after management fees, incentive fees, fund expenses and taxes — always below the fund's Gross IRR, sometimes far below.
- Internal Rate of ReturnThe rate at which the present value of an investor's cash outflows equals the present value of inflows — an annualised return that, unlike ROI, accounts for when each cash flow happened.
- Since-inception IRRThe internal rate of return computed from every cash inflow and outflow since a Category III AIF's launch date up to the reporting date — how a live fund's cumulative performance is reported to SEBI.