What it means
The internal rate of return (IRR) is the single yearly rate that makes the present value of an investment's cash inflows and outflows equal to zero. It is a standard way to judge private equity funds, property projects and other investments with money going in and coming out at different times.
Pooled IRR applies the same calculation to a combined set of cash flows. To build the pooled cash flow, the analyst adds up all contributions and distributions that happened on each date across the investments in the group.
The result is a single timeline of net inflows and outflows. The IRR of that timeline is the pooled IRR.
The reason to pool is to avoid the distortion of averaging. A simple average of two IRRs gives equal weight to a small, high-return investment and a large, low-return one, which exaggerates the group's performance.
Pooled IRR automatically gives more weight to larger and longer-lasting investments, so it reflects the money actually at work. Investors use it to evaluate a fund of funds, a vintage year of private equity commitments, a property portfolio or a firm's whole set of projects.
It answers the question of what return the investor earned on all the capital committed. Reporting standards for private funds often show a pooled return for the whole fund as well as returns for individual investors.
There are nuances. IRR assumes that interim cash can be reinvested at the same rate, which is often unrealistic, and the result can be sensitive to the timing of large cash flows.
Some cash flow patterns also produce more than one mathematical solution. For these reasons, analysts often show pooled IRR alongside the multiple of invested capital, which compares the total money returned with the total money invested.
The two figures together describe both the speed and the size of the return.
In practice
Real-world examples.
Example
A pension fund holds five private equity commitments. It combines all capital calls and distributions across the five and reports one pooled IRR, which tells the trustees how the programme performed as a whole.
Example
A property company tracks a portfolio of three buildings, each bought in a different year. The finance team pools the cash flows to show investors a single IRR for the portfolio, rather than three that cannot easily be compared.
Example
A venture investor evaluates a vintage year of twenty start-up investments. The pooled IRR is far below the best single deal, because a few strong winners are balanced by many that lost money.
Formula
Calculation
Pooled IRR = the rate r that solves: sum of (net cash flow in period t / (1 + r)^t) = 0, using the combined cash flows
Suppose Investment A puts in $300,000 now and returns $330,000 after one year, while Investment B puts in $100,000 now and returns $120,000 after one year.
IRR of A = (330,000 - 300,000) / 300,000 = 10%.
IRR of B = (120,000 - 100,000) / 100,000 = 20%.
Simple average of the two = (10% + 20%) / 2 = 15%.
Pooled cash flows: -$400,000 now (300,000 + 100,000) and +$450,000 after one year (330,000 + 120,000).
Pooled IRR = (450,000 - 400,000) / 400,000 = 12.5%.
The pooled figure of 12.5% is lower than the simple average because the larger investment earned the lower rate.Case study
Seen in the real world.
Alder Ridge Partners is a fictional fund manager reporting on two property funds. Fund One returned an IRR of 18% on $20,000,000, and Fund Two returned 6% on $80,000,000. In this illustrative report, the marketing team wants to advertise an average IRR of 12%.
The finance director objects. She points out that 80% of the money was in Fund Two, so the capital-weighted result is closer to 0.2 x 18% + 0.8 x 6% = 3.6% + 4.8% = 8.4%. She argues that a pooled IRR calculated from the combined cash flows is the fairest number to publish.
The team uses the pooled figure and explains it in the report. The company avoids an overstated headline, and investors receive a clearer picture of the performance of their money.
Watch out
Common mistakes.
- Averaging individual IRRs instead of pooling the cash flows. This ignores the size and timing of the money in each investment.
- Assuming a higher IRR always means more profit. A short investment can have a high IRR but a small total gain.
- Forgetting the reinvestment assumption. IRR assumes cash flows can be reinvested at the same rate, which may not be possible.
Questions
People also ask.
How is pooled IRR different from a time-weighted return?
Pooled IRR depends on the timing and size of cash flows, while time-weighted return removes the effect of those flows to judge the manager's decisions.
Can pooled IRR be negative?
Yes. If total money returned is less than total money invested, the pooled IRR is negative.
What tool calculates it?
A spreadsheet IRR function applied to the combined, dated cash flows will do it, and XIRR handles irregular dates.
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