How IRR manipulation deceives private equity investors

 "IRR has become the theatre of private equity performance," says Oxford finance professor Ludovic Phalippou. "It delivers a beautiful illusion. Until someone looks at the maths."

Private equity firms use IRR manipulation to inflate their performance claims. UK regulators must step in to protect investors from these misleading metrics.

Private equity has become the investment world's most seductive sales pitch. Firms promise returns that seem almost magical. KKR claims 25.5% annually since 1976, while Apollo boasts 39%. For pension funds and increasingly retail investors, these numbers are irresistible. But scratch beneath the surface and a troubling picture emerges: an industry built on fundamentally misleading mathematics.

The weapon of choice? Internal Rate of Return, a metric so easily manipulated that it bears little resemblance to actual investment performance. As Professor Ludovic Phalippou of Oxford puts it, IRR has become "the theatre of private equity performance" — a beautiful illusion that crumbles under scrutiny.

A recent Financial Times analysis by Phalippou exposed the mathematical impossibility of these claims. If KKR's first £31 million fund truly compounded at 26% annually since 1976, it would be worth £2.6 trillion today. Apollo's early funds would be worth £74 trillion—nearly global GDP. These aren't just optimistic projections; they're mathematical fantasies that reveal how deeply flawed PE performance reporting has become.

The mathematics of deception

Why are private equity returns so divorced from reality? The answer lies in how IRR manipulation works. "Any IRR over 15% is wrong," Phalippou states bluntly, exposing a metric that isn't actually a rate of return at all.

IRR is what Phalippou calls a "mathematical artefact" that assumes every pound distributed gets reinvested at the same rate it was originally earned. This creates a perverse dynamic where early cash flows dominate calculations, while decades of subsequent performance barely register. A strong early exit can lock in high return figures that remain virtually unchanged regardless of later disasters.

This stickiness creates fertile ground for gaming. Fund managers know they can boost IRR by quickly selling successful investments while holding onto struggling ones, or by borrowing for initial investments rather than calling capital from investors. The result? Performance figures that tell investors almost nothing about a fund manager's actual skill or likely future returns.

IRR manipulation: a masterclass in misdirection

The consequences extend far beyond academic debates about methodology. Phalippou's research, using conservative assumptions that favour the industry, found that private equity funds launched between 2006 and 2016 delivered returns around 8.6% annually—broadly matching the S&P 500.

This is particularly damning. Private equity should outperform public markets by at least 300 basis points to justify its higher fees, reduced liquidity, and increased complexity. Instead, after accounting for IRR manipulation, the industry appears to deliver public market returns while charging premium fees.

The timing couldn't be worse. The government is actively pushing retail investors toward private equity under the banner of "supporting economic growth." Yet most individual investors lack the expertise to decode IRR manipulation or understand why a 25% claimed return might actually represent 8% performance.

A dangerous regulatory vacuum

Despite these obvious flaws, UK regulators largely ignore IRR manipulation. The FCA's 2025/26 work programme emphasises protecting consumers from misleading promotions, yet private equity's performance claims—the most fundamental investment information—remain unscrutinised.

This regulatory blind spot becomes more troubling as retail exposure increases. Institutional investors might understand IRR's limitations, but ordinary savers typically don't. Without intervention, IRR manipulation creates serious information gaps that leave consumers exposed to fundamentally misleading claims about investment performance.

The contrast with other regulatory priorities is stark. The FCA has cracked down on misleading pension transfer advice and inappropriate investment promotions. It has fined firms for inadequate risk warnings and unclear fee structures. Private equity's performance reporting encompasses all these issues, yet receives minimal attention.

Learning from enhanced enforcement

The Competition and Markets Authority's new powers under the Digital Markets, Competition and Consumer Act 2024 provide a useful template. Since April, the CMA can impose fines of up to 10% of global turnover for misleading claims and aggressive sales practices targeting vulnerable consumers.

IRR manipulation arguably falls squarely within these criteria. When fund managers present decades-old exit multiples as current return rates, they're providing objectively false information. When they target pension funds and retail investors with these inflated figures, they're exploiting information asymmetries that prey on vulnerability.

Yet while the CMA gains powerful new enforcement tools, the FCA's role is being systematically weakened. The regulator's five-year strategy explicitly promises "less intensive supervision" and "fewer enforcement actions." This creates a dangerous paradox: as financial products become more complex and retail exposure increases, oversight is diminishing precisely when it's needed most.

The path forward

Solutions exist, and they're not complex. Phalippou suggests requiring "horizon IRRs"—returns calculated over rolling periods that reflect actual investment timeframes. When measured this way, KKR's returns drop to around 12% over 20 years, while Yale's performance falls to 11.5%. Still respectable, but hardly the investment alchemy current marketing suggests.

More fundamentally, the term "Internal Rate of Return" should be banned from marketing materials altogether. "Internal Discount Rate" would be more honest. The FCA should also require clear warnings that IRRs above 15% are "not meaningful" as performance measures — similar to how firms must report negative IRRs as "n.m."

The regulator's stated goal of facilitating "informed risk-taking" makes such intervention both necessary and timely. Investors can't make informed decisions based on IRR manipulation and fundamentally misleading metrics.

A question of market integrity

The private equity industry will resist these changes, arguing that institutional investors understand IRR's limitations. This misses the point entirely. Even sophisticated investors rely on comparable metrics across funds and asset classes. When an entire industry manipulates the same flawed measurement, market discipline breaks down completely.

As private equity expands into retail markets, the stakes rise dramatically. Individual investors navigate complex performance metrics without the analytical resources available to institutions. They rely on regulators to ensure basic investment information is accurate and comparable.

The stakes couldn't be higher. As private equity targets ordinary savers through pension funds and ISAs, the information asymmetry becomes dangerous. Retail investors lack the sophisticated analysis teams that might spot IRR manipulation, yet they're being sold the same inflated performance claims. The FCA has a choice: act now to clean up these metrics, or watch as millions of UK savers are misled by private equity's mathematical sleight of hand. In a market built on trust, allowing such deception to continue is not just wrong but reckless.

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