TL;DR: IRR (internal rate of return) is the annualized return rate at which a deal's cash flows break even in present-value terms. Lower-middle-market PE firms target 20-25% net IRR as a practitioner benchmark. IRR has a critical flaw: it assumes cash flows get reinvested at the same rate, which almost never happens. Pair it with MOIC and hold period before trusting it.
Every time I sit across the table from a seller or a co-investor, somebody mentions IRR. Internal rate of return. The number that shows up on every investment memo and gets cited in every fund pitch deck.
Most people nod. Few can explain it. Fewer still know when it lies.
According to PitchBook's Q1 2026 Private Equity Report, lower-middle-market deals tracked by StepStone since 2009 have delivered a 39% gross IRR and 3.3x TVPI at the deal level. Gross is the operative word. By the time management fees, carried interest, and fund expenses come out, net returns land materially lower. CalSTRS — one of the most transparent pension systems in the country — reported net fund-level IRRs of 17.89% to 17.97% for PE funds from its 2014-2018 vintages.
That gap between gross and net is where most people get surprised. Here is what you actually need to know about IRR before you use it to evaluate a deal.
What IRR actually is
IRR is the discount rate that makes the net present value of all cash flows from an investment equal to zero. That sounds abstract. In plain terms: it is the annualized return rate at which the present value of what you put in exactly equals the present value of what you get back.
The math solves for r in this equation:
0 = Initial Investment + CF1/(1+r) + CF2/(1+r)² + CF3/(1+r)³ + ... + CFn/(1+r)^n
Where CF = cash flow at each period and r = IRR.
You cannot solve for r algebraically. Software iterates until it converges on the answer. Excel uses XIRR for this; most deal models do too.
A 25% IRR over a five-year hold means your invested capital grew at 25% per year, compounded, after accounting for the timing of every cash flow in and out.
What a good IRR looks like in the lower-middle-market
Practitioner convention in lower-middle-market PE runs in the 20-25% net IRR range as a return target. This is not a published industry standard. It is what sponsors underwrite to and what LPs expect to receive net of fees.
Large-cap PE firms targeting $1B+ deals typically underwrite to 15-20% net IRR. Smaller deals carry more risk per dollar, so the return expectation is higher.
At Patriot Growth Capital, we focus on the $2M-$10M EBITDA range. The businesses we acquire are operationally fixable. That means IRR depends less on financial engineering and more on the operator in the seat. A 20% IRR on a $3M EBITDA business requires real operational improvement, not just multiple arbitrage.
Context matters. A 22% IRR over three years is not the same as a 22% IRR over seven years. The money returned in year three gets reinvested. The money returned in year seven does not.
IRR versus MOIC: why you need both
IRR measures the rate. MOIC (multiple on invested capital) measures the size. Both matter. Neither tells the full story alone.
A 3.0x MOIC over three years produces a very different IRR than a 3.0x MOIC over seven years. On the three-year hold, IRR is approximately 44%. On the seven-year hold, IRR drops to approximately 17%.
That is why sponsors report both. IRR rewards speed. MOIC rewards patience and scale. A PE firm can game IRR by returning capital early through dividend recapitalizations, which boosts the annualized rate while not necessarily improving the total value created for LPs.
When I look at a deal, I want to see:
- IRR at the target hold period (typically 5 years in LMM)
- MOIC at the same hold period
- IRR sensitivity to a one-year delay in exit
- MOIC sensitivity to exit multiple compression (what if we sell at 5x instead of 7x?)
If the deal only pencils at the top of the range on all four metrics, it is too fragile. Real deals survive stress tests.
The reinvestment rate problem
Here is the flaw no one talks about at the LP meeting: IRR assumes every cash flow you receive gets reinvested at the same IRR. That assumption is almost always wrong.
A McKinsey analysis of this exact issue found that a project showing a 77% IRR dropped to 16% under a more realistic reinvestment assumption. The math inflates returns significantly when cash flows come back early and the formula pretends you put them to work at the same rate.
Modified Internal Rate of Return (MIRR) fixes this by applying a separate reinvestment rate (typically the firm's cost of capital or a conservative market rate). MIRR is more honest. It is also less flattering, which is why you rarely see it in pitch decks.
The Public Market Equivalent (PME) benchmark takes a different approach: it compares your PE fund's cash flows to what would have happened if those same dollars went into a public market index. If your PE fund returned 18% net IRR but the S&P 500 would have returned 15% over the same period, you generated real alpha. If not, you took illiquidity risk for nothing.
The most sophisticated LPs track PME. Ask any fund manager about their PME and watch their posture change.
How operators use IRR in practice
If you are buying a business, IRR is a planning tool, not a report card. You use it to reverse-engineer what you need the business to do.
Start with your required return. Say 22% net IRR over a 5-year hold. At a typical 3x equity co-investment structure and 6x entry multiple on $3M EBITDA, what EBITDA does the business need to hit at exit to clear your target at a 6.5x exit multiple?
Work backward from the exit. That tells you the revenue growth rate and margin improvement you need to deliver. Now stress test it. What does IRR look like at a 5.5x exit multiple? What if EBITDA growth stalls for two years?
This exercise is more useful than any model sensitivity table. It forces you to confront the operational assumptions buried in the return projection.
For search fund operators specifically: your personal IRR is somewhat irrelevant because you are receiving a salary, carry, and equity rollover, not purely an investment return. What matters is the equity value you build and your ability to exit at a multiple that reflects that value. IRR still matters to your investors and to the bank if you are using SBA financing. Build a model that shows it, but do not let it drive decisions that should be driven by operational logic.
You can find a breakdown of how LMM PE deals are structured and priced in our lower-middle-market private equity guide.
What IRR does not tell you
IRR does not tell you the dollar return. A 30% IRR on a $500K check is less valuable than a 20% IRR on a $5M check. Scale matters. IRR ignores it.
IRR does not tell you the risk. Two deals can have identical projected IRRs with completely different risk profiles. A business with 80% recurring revenue and a fragmented customer base is not the same bet as a business with three customers and a contract renewal coming up.
IRR does not tell you how much value the operator created versus how much came from multiple expansion. In a rising market, a mediocre operator can show a strong IRR. In a flat market, a great operator might show a lower one. The metric does not decompose what drove the return.
Use IRR as a screening tool. Use your operational assessment as the final filter.
Frequently Asked Questions
What is a good IRR for lower-middle-market private equity?
Practitioner convention targets 20-25% net IRR for LMM PE deals in the $2M-$10M EBITDA range. This is higher than large-cap PE (typically 15-20% net) because smaller businesses carry more operational and liquidity risk. These are return targets, not guaranteed outcomes.
How does IRR differ from MOIC in private equity?
IRR measures the annualized rate of return and penalizes slow exits. MOIC measures the total multiple of invested capital and does not account for time. A deal can show a strong MOIC but weak IRR if the hold period is long. You need both numbers to fully evaluate a deal.
Why is IRR sometimes misleading in PE?
IRR assumes that all cash flows received are reinvested at the same IRR rate. This assumption rarely holds in practice. It can be inflated by early distributions like dividend recapitalizations. Modified IRR (MIRR) and Public Market Equivalent (PME) are more accurate benchmarks for evaluating real performance.
How do search fund operators use IRR when buying a business?
Search fund buyers use IRR to reverse-engineer the operational targets a business must hit to deliver investor returns. Starting from a 20-22% net IRR target, they back into required EBITDA growth and exit multiple assumptions, then stress test those assumptions against realistic downside scenarios before signing an LOI.
IRR is one number in a deal model. It is not the deal. Build the business right, and the IRR takes care of itself. Chase the IRR target without operational conviction, and you will hit neither.
