What Is the Pooled Internal Rate Of Return?
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 internal rate of return (IRR) of the portfolio can then be calculated from this pool of cash flows.
The Formula for PIRR Is
Where Ct is the pooled cash flows expected at time t and r is the risk-free rate of return.
- Pooled IRR (PIRR) is a method for calculating the returns from a number of concurrent projects in which an IRR is calculated from the aggregatred cash flows of all the cash flows.
- The pooled IRR is the rate of return at which the discounted cash flows (the net present value) of all projects in aggregate are equal to zero.
- The pooled IRR concept can be applied, for example, in the case of a private equity group that has several funds.
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 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 is most often used when computing the rate of return associated with the expected cash flows of a particular project. In reality, however, a firm may have several concurrent projects for which it must make budget allocation decisions. This is especially true for private equity firms or venture capital funds that have several investments going on at any given time. While individual IRR calculations can be used to evaluate each individual project, the pooled IRR is better used to understand the internal rate of return for the firm's entire portfolio in aggregate.
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 hide bad projects and mute the positive effect of lucrative projects. Both individual and pooled IRR should be conducted to see if any outliers exist.