IRR and Fund Cash Flows, Explained

Short answer: Money moves through a private fund in a predictable pattern: investors commit capital, the fund calls it when it needs it, invests, and later distributes cash back through the waterfall. The internal rate of return (IRR) measures that pattern as a single annual percentage that takes timing into account, while a multiple such as TVPI or DPI measures how much money came back, regardless of when. Both are pre-tax numbers, and neither tells you what the investor's K-1 will show in a given year.

How money moves through a fund

Commitment. An investor (LP) signs up to provide, say, $10 million over the fund's life. Nothing moves yet.
Capital calls. When the fund buys an asset or pays fees and expenses, it calls part of the commitment, with the notice period set in the fund agreement. The called amount is paid-in capital; the rest is unfunded commitment.
Investment period. The fund invests, typically over the first few years, and collects income: rent, interest or dividends.
Distributions. When assets produce cash or are sold, the fund distributes through the waterfall: return of capital, then a preferred return, then the manager's catch-up and carried interest or promote. Some agreements let the fund recall certain distributions and invest them again.
Wind-down. Remaining assets are sold and the fund is liquidated.

The funds flow at a closing

On a single deal, the funds flow memo is the closing-day spreadsheet that shows every dollar's source and destination: equity called from investors, loan proceeds, the purchase price paid to the seller, payoff of existing debt, closing costs, fees and reserves. Sources must equal uses. For tax, the funds flow is the starting point for working out the asset's cost basis, which costs are capitalised into it, and which are deducted or amortised.

What IRR measures

The IRR is the annual discount rate at which the present value of all the cash an investor puts in equals the present value of all the cash they get back. In plain terms, it is the steady annual return that would turn the investor's outflows into their inflows on the same dates.

Because IRR is a money-weighted return that depends on the date of every cash flow, the same profit earned faster produces a higher IRR, and a distribution that comes early raises IRR even if the total stays the same.

The industry uses two versions:

Gross IRR is measured at the level of the investments, before management fees, expenses and carried interest.
Net IRR is what investors actually earned: their capital calls, including fees, against their distributions after carry, with unrealised investments counted at their reported value (NAV) at the end.

The multiples

Multiples ignore timing and show how much value has come back per dollar invested:

DPI (distributions to paid-in) = cash distributed ÷ capital paid in. It is the only one that is cash in hand.
RVPI (residual value to paid-in) = remaining NAV ÷ capital paid in.
TVPI (total value to paid-in) = DPI + RVPI.
MOIC (multiple on invested capital) is usually quoted deal by deal: total value ÷ amount invested.

A fund with a high IRR but a low DPI has produced attractive returns on paper, but has not yet returned much cash.

Worked examples

All four investments below put in $100 and get back $150 in total, apart from the last one.

Cash flows	IRR	Multiple
A: −$100 today, +$150 in year 3	14.47%	1.50x
B: −$100 today, +$50 in year 1, +$100 in year 3	19.74%	1.50x
C: −$100 in year 1, +$150 in year 3 (credit line interest ignored)	22.47%	1.50x
D: as C, but $6 of credit line interest comes out of the proceeds	20.00%	1.44x

A to B: returning $50 two years earlier lifts IRR by more than five points, with the same total profit.
A to C: the investment is the same, but the investor's money goes in a year later because the fund first borrowed on a subscription line of credit and called capital only to repay it. The investor's IRR jumps from 14.47% to 22.47%.
C to D: once the line's interest is paid, the investor ends up with less money (1.44x instead of 1.50x) but still a higher IRR than A.

This is why the Institutional Limited Partners Association (ILPA) has asked managers to report net IRR both with and without the use of subscription lines. In its 2017 guidance, ILPA said delaying capital calls this way enhances IRR, particularly early in a fund's life, and makes performance harder to compare across funds.

IRR inside the waterfall

Many waterfalls, especially in real estate, use IRR as the hurdle: the preferred return is often an 8% IRR, and promote tiers step up at higher IRRs. Because IRR depends on timing, two deals with the same profit can pay the sponsor very different promotes. Deals that pay out early can hit IRR hurdles easily but earn a low multiple, which is why some agreements test both an IRR and a minimum multiple before the promote kicks in.

Where tax fits in

IRR and multiples are pre-tax and measured on cash. Tax follows different rules:

Capital calls are not taxable. Paying in capital simply adds to the investor's basis in the fund.
Distributions are generally not taxable either, as long as cash does not exceed the investor's basis in the partnership interest. What is taxed is the investor's share of the fund's income, reported on the K-1 whether or not any cash was distributed.
So cash and taxable income rarely line up. A fund can distribute cash that is mostly a return of capital in a year with little taxable income, or allocate taxable gain and interest in a year with no distribution. That gap is phantom income, and it is why many funds make tax distributions to cover partners' tax on allocated income.
After-tax returns differ by investor. The same fund can produce very different after-tax IRRs for a taxable individual, a tax-exempt pension fund facing UBTI, and a foreign investor facing ECI and withholding.

This explainer is general information, not tax or investment advice.