How Managers Can Engineer IRR and What to Watch For

Internal rate of return is the most widely quoted performance figure in private investing, and its popularity is precisely the problem. Because IRR is exquisitely sensitive to the timing of cash flows, a manager can inflate it without creating a dollar of additional value for investors, simply by controlling when capital is called and returned. That makes it hard to tell, from the headline number alone, whether a manager genuinely outperformed or merely engineered the optics. Heritage Hill believes investors owe it to themselves to understand the most common form of this financial engineering: the subscription line.

What a Subscription Line Is

A subscription line, sometimes called a capital call facility, is a line of credit a bank extends to a fund. Rather than being secured by the fund's assets, it is collateralized by the investors' unfunded commitments. The bank is comfortable lending against those commitments because it knows the manager can always call capital from investors to repay the balance.

Used for their intended purpose, subscription lines are perfectly reasonable and even helpful. They let a manager close on an attractive deal on short notice without waiting for a capital call to clear. They spare investors the nuisance of frequent small draws, the kind that might represent only a percent or two of a commitment at a time. Banks typically extend generous terms, sometimes lending well over half of outstanding commitments, and often wait until the manager has already called a modest slice of investor capital before advancing credit, as confirmation that investors are ready and able to fund.

So far, so useful. The trouble begins when a manager exploits the same tool to manipulate IRR.

How the Manipulation Works

The mechanism is simple. IRR is calculated from the timing of the money investors actually put in and take out. The longer a manager can delay calling capital from investors, the shorter the apparent holding period, and the higher the reported IRR on the capital investors eventually contribute.

Here is the maneuver in practice. Instead of calling investor capital when a deal is acquired, the manager funds the acquisition with the subscription line and holds the deal on that line for as long as possible. Subscription facilities often mature around the time the fund's investment period ends, which can be several years out, giving the manager a long runway. During that stretch, investors sit on their commitments, unable to deploy that money elsewhere, and often paying fees, while the clock that determines their IRR simply has not started.

Consider two versions of the same deal. In the first, the manager calls the full commitment up front, the money is invested, and after several years the investment returns a healthy profit, producing a respectable IRR. In the second, identical in every economic respect, the manager funds the deal on the subscription line, waits, and only calls investor capital shortly before returning it along with the same profit. Because investors' money was tied up for a far shorter measured period, the reported IRR balloons to a multiple of the first figure.

The second manager created no additional value. The property performed exactly the same. The only thing that changed was the timing of the capital call, and yet the reported IRR looks vastly superior.

Why This Should Concern Investors

The consequences run deeper than a misleading statistic. Performance fees are frequently tied to IRR, so the manager who financially engineered the higher number often collects a larger incentive fee for producing no incremental value. In effect, the manager is borrowing cheaply against the investors' own balance sheet, their unfunded commitments, and then charging them more for the privilege.

There is also a real cost to capital efficiency. An investor who commits money expects it to be put to work in a reasonable timeframe. No one signs up to pledge capital and then wait years for it to be called while their commitment sits idle, or to have their personal balance sheet quietly leveraged so a manager can boost fees.

Looking Under the Hood

None of this makes subscription lines inherently bad. Nearly every fund uses one, and many managers use them responsibly. The task for investors is to distinguish the responsible users from the ones who lean on the facility to dress up returns. A manager reporting a very high IRR will always raise capital more easily than one reporting a more modest figure, even when the higher number is manufactured, so the incentive to engineer is persistent.

The remedy is diligence. Ask how the fund uses its subscription line, how long deals are typically held on the line before capital is called, and how performance fees are calculated. Evaluate a manager not just on the IRR they report but on their demonstrated ability to deploy committed capital promptly and to create genuine value once it is deployed. And always pair IRR with the equity multiple, which is far harder to manipulate through timing. The managers worth backing are the ones whose returns survive that closer look.

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Partner with Heritage Hill

Because a headline IRR can be engineered through the timing of capital calls, Heritage Hill holds itself to returns that survive scrutiny — deploying committed capital promptly, pairing IRR with the harder-to-manipulate equity multiple, and creating genuine value rather than optical gains.

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This material is for informational and educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any security. Private real estate investments involve risk, including the possible loss of principal. Past performance is not indicative of future results.