Pooled Internal Rate of Return (PIRR)

What Is the Pooled Internal Rate of Return (PIRR)?

Pooled internal rate of return (PIRR) is a method of calculating the overall internal rate of return (IRR) of a portfolio that consists of several projects by combining their individual cash flows. In order to calculate this, you need to know not only the cash flows received but also the timing of those cash flows. The overall IRR of the portfolio can then be calculated from this pool of cash flows.

The pooled internal rate of return can be expressed as a formula:

I R R   =   N P V   =   ∑ t = 1 T C t ( 1 + r ) t   −   C 0   =   0 where: I R R   =   internal rate of return N P V   =   net present value C t   =   the pooled cash flows expected at time  t \begin{aligned}&IRR\ =\ NPV\ =\ \sum^T_{t=1}\frac{C_t}{(1+r)^t}\ -\ C_0\ =\ 0\\&\textbf{where:}\\&IRR\ =\ \text{internal rate of return}\\&NPV\ =\ \text{net present value}\\&C_t\ =\ \text{the pooled cash flows expected at time }t\\&r\ =\ \text{the risk-free rate of return}\end{aligned} IRR = NPV = t=1∑T(1+r)tCt − C0 = 0where:IRR = internal rate of returnNPV = net present valueCt = the pooled cash flows expected at time t

Understanding the Pooled Internal Rate of Return

The internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same formula as NPV does. The pooled IRR is the rate of return at which the discounted cash flows (the net present value) of all projects in the aggregate are equal to zero.

The pooled internal rate of return (PIRR) can be used to find the overall rate of return for an entity running multiple projects or for a portfolio of funds each producing their own rate of return. The pooled IRR concept can be applied, for example, in the case of a private equity group that has several funds. The pooled IRR can establish the overall IRR for the private equity group and is better suited for this purpose than say average IRR of the funds, which may not give an accurate picture of overall performance.

PIRR Versus IRR

IRR computes the return of a particular project or investment based on the the expected cash flows associated with that project or investment. In reality, however, a firm will undertake several projects simultaneously, and it has to figure out how to budget its capital among them. This issue of concurrent projects is especially prevalent in private equity or venture capital funds that provide capital to several portfolio companies at any given time. While you can compute separate IRRs for each of these projects, pooled IRR will paint a more cohesive picture of what is going on taking into account all of the projects at the same time.

Limitations of PIRR

As with IRR, PIRR can be misleading if used in isolation. Depending on the initial investment costs, a pool of projects may have a low IRR but a high NPV, meaning that while the pace at which the company sees returns on a portfolio of projects may be slow, the projects may also be adding a great deal of overall value to the company.

The other issue that is unique to PIRR is that since cash flows are pooled from various projects, it may conceal poorly performing projects and mute the positive effect of lucrative projects. Both individual and pooled IRR should be conducted to identify the existence of any outliers.