Net IRR
Also written Net internal rate of return
An 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.
In plain language
A fund's investments can earn 18% a year while its investors earn 13%. Both numbers are honest. They are simply measured at different places.
Gross IRR is measured at the fund level, before management fees, incentive fees, fund expenses and taxes. Net IRR is measured at the investor level. The workbook explains that Net IRR "treats all fund-level expenses as the expenses borne by the investors, indirectly", so the investor's cash outflows include not just capital contributions but also set-up costs, yearly expenses, management fees, incentive fees and taxes. Hence Net IRR will be lower than the Gross IRR.
Both are forms of IRR, the rate at which the present value of cash outflows equals the present value of inflows, and both can be computed since inception — for a fund already liquidated, that is the life-time IRR.
How it works
The workbook's Example 7 — Fund ABC, a Category III AIF with Rs 50 crore committed on 1 January 2019, five-year life, buy-and-hold strategy.
Gross IRR. Outflow Rs 50 crore on 1 January 2019; inflow equal to Gross Asset Value at the end of 2023.
- Best case: Rs 115 crore → 50 = 115 ÷ (1 + IRR)⁵ → 18.13%
- Worst case: Rs 70 crore → 6.96%
Net IRR. The timing of every cash flow matters:
- capital (Rs 50 crore) and the initial set-up cost (Rs 1.25 crore) at the beginning of year 1;
- yearly fund expenses (Rs 30 lakh) and management fees including GST at the end of each year;
- incentive fees and tax at the end of 2023;
- inflow: Gross Asset Value at the end of 2023.
Computed with Excel's XIRR: 12.98% best case, 3.48% worst case.
| Gross IRR | Net IRR | Change | Change over Gross IRR | |
|---|---|---|---|---|
| Best case | 18.13% | 12.98% | 5.15% | 28.4% |
| Worst case | 6.96% | 3.48% | 3.48% | 50% |
The lessons the workbook draws. Net IRR can be substantially below Gross IRR when fixed costs — set-up costs, operating expenses, management fees and incentive fees — are high. And the proportional hit is larger in the worst case, because fixed costs eat a bigger share of a smaller return.
Reporting. IRR is reported to SEBI on a quarterly or monthly basis by a Category III AIF, and a consolidated IRR across all the manager's Category III AIFs is also reported.
The formula
Gross IRR: rate r where Capital calls = Gross distributions / (1 + r)^t
(fund level; ignores fees, expenses and taxes)
Net IRR: rate r where PV of (capital + set-up cost + expenses + management fees
+ incentive fees + taxes) = PV of inflows
(investor level; computed with XIRR on dated cash flows)
A worked example
Illustrative figures. Mr Kapoor invests Rs 2 crore in a close-ended Category III AIF for three years. At the end, his share of gross asset value is Rs 2.90 crore.
Gross IRR = (2.90 / 2.00)^(1/3) - 1 = about 13.2%
His statement also shows, attributable to his units: set-up cost of Rs 3 lakh at the start; management fee plus GST of about Rs 4.5 lakh, and expenses of Rs 1 lakh, at the end of each year; incentive fee of Rs 6 lakh and tax of Rs 5 lakh at the end of year 3.
His net cash flows are therefore:
| Point in time | Cash flow (Rs lakh) |
|---|---|
| Start | −203.0 |
| End of year 1 | −5.5 |
| End of year 2 | −5.5 |
| End of year 3 | +290 − 5.5 − 6 − 5 = +273.5 |
Solving for the rate that sets the present value of these flows to zero gives a Net IRR of roughly 8.7%.
The fund's factsheet may lead with 13.2%. What Mr Kapoor actually earned is about 8.7% — a gap of about 4.5 percentage points, the kind of gap the workbook's Fund ABC example shows between 18.13% and 12.98%.
Why NISM asks about it
Chapter 6 (Fees Structure, Fund Performance and Benchmarking) defines since-inception, gross and net IRR at 6.2.1.1 and works Fund ABC's best and worst cases through them in Example 7, building on the fee examples in 6.1. Chapter 6's alpha illustration also uses Net IRR rather than Gross IRR, on the assumption that investors ultimately bear the fund's expenses and fees. Expect questions on what is deducted for Net IRR, why it is lower, why the gap widens in poor years, and how cash flow timing is treated.
Common exam traps
- Gross IRR is fund level; Net IRR is investor level. Net IRR includes set-up costs, expenses, management fees, incentive fees and taxes as outflows.
- Net IRR is always lower than Gross IRR in the workbook's framing, because all fund-level expenses are treated as borne by investors.
- The proportional gap is bigger in bad years — 50% of gross IRR in the worst case, against 28.4% in the best case.
- Timing matters. Capital and set-up costs at the beginning of year 1; expenses and management fees at the end of each year; incentive fees and tax at the end.
- Since-inception IRR for a liquidated fund is also called life-time IRR.
- Use Net IRR, not Gross IRR, when computing alpha in the workbook's CAPM example.
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.
- Net returnThe return on an AIF's NAV after fund expenses, costs and management fees — measured before incentive fees (pre-incentives) or after them (post-incentives, what the investor actually keeps).
- Total Value to Paid-in CapitalA fund's investment multiple: cumulative distributions plus the residual value of unsold investments, divided by paid-in capital — equivalently, DPI plus RVPI.
- 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.
- 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.
- Benchmarking AgencyAn agency notified by an AIF association covering at least 33% of AIFs, which collects AIF performance data and publishes industry benchmarks and benchmark reports for individual funds.
- Gross IRRAn 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.
- Market Risk PremiumThe excess return a benchmark index earns over the risk-free rate — the "Rm − Rf" term in the CAPM formula used to compute a Category III AIF's expected return and alpha.
- 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.