alt 2: Alternative Investment Performance and Returns

Why is performance appraisal of alternative investments more difficult than traditional assets?

• Illiquidity

• Long investment horizons

• Staggered capital commitments

• Complex fee structures

• Less efficient markets

• Returns are often non-normal, so traditional risk/return measures are less reliable

What makes performance comparison between alternative and traditional assets difficult?

• Differences in cash flow timing

• leverage use

• valuation methods

• fee/tax structures.

What are the three phases of the alternative investment life cycle?

1. Capital commitment

• Capital called gradually

• Fees and setup costs dominate

• Returns usually negative

2. Capital deployment

• Funds invested into assets/projects

• High expenses (development, restructuring, operations)

• Cash outflows > inflows

3. Capital distribution

• Exits occur (IPO, sale, liquidation)

• Strong positive returns realised

• Fund performance accelerates then stabilises

What is the J-curve effect?

Initial negative returns followed by rising returns as investments mature and exit.

Why is IRR important in alternative investments, how does it work, what does it measure?

• Primary metric for private equity and real assets

• Captures:

  • Timing of capital calls

  • Timing of distributions

• Reflects manager skill in capital allocation + timing decisions

limitations of IRR

• Assumes reinvestment rate

• Sensitive to cash flow timing assumptions

What is MOIC?

• Multiple of Invested Capital = $\frac{\text{realised gains + unrealised gains}}{\text{invested capital}}$

• Measures total return multiple (e.g., 2×, 3×)

advantages and limitations of MOIC

• Advantages:

  • Simple and intuitive

• Limitation:

  • Ignores time (2× in 2 years ≠ 2× in 15 years)

  • It ignores the timing of cash flows.

leveraged return formula

r_L = Leveraged portfolio return/Cash position =

$$r_{L}=r+\frac{V_{b}}{V_{c}(r–r_{b})}$$

V_c = cash investment

r = periodic rate of return

r_{b =} periodic borrowing rate to increase the size of its investment by borrowed funds of

V_b = borrowed funds ,

r_L = leveraged rate of return

What is fair value in alternative investments?

Estimated market-based exit price in an orderly transaction.

What are the three levels of fair value inputs?

• Level 1: Market prices

• Level 2: Observable inputs

• Level 3: Unobservable/model-based inputs

Which assets typically use Level 3 valuation?

Private equity, real estate, and other illiquid investments.

Why is Level 3 valuation problematic?

• Model-based valuation (“mark-to-model”): bias and liquidity misrepresentation

• Limited market data

• Valuations may:

  • Smooth volatility

  • Overstate stability

  • Diverge from liquidation value

• Requires strong governance and independent validation

Why are alternative investment fee structures more complex?

• performance-based incentives

• varying timing of investment → different fee burdens for similar performance.

Why do alternative investments use performance fees?

align manager compensation with investment performance and investor outcomes.

Why are hedge fund strategies more expensive to run?

• Complex strategies

• Leverage

• Performance-based compensation

• Lockups and redemption restrictions

What is a redemption fee?

• Fee charged when investors withdraw capital

• Purpose:

  • Discourage withdrawals

  • Offset transaction costs caused by redemptions

What is a lockup period and why are they used?

• Minimum holding period before investors may redeem or withdraw funds

• To provide managers enough time to execute long-term strategies.

What is a gate provision and why are they used?

• A restriction limiting investor redemptions during periods of stress or illiquidity

• To prevent forced asset sales and protect remaining investors.

what are fees Based on Liquidity & Investment Size

• Longer lockups → lower fees

• Larger investors often negotiate:

  • Lower management fees

  • Lower incentive fees

What are founders shares?

• Incentives for early investors in new funds

• Offer reduced fees

What are “either/or” fee structures?

Manager chooses:

• Lower fixed management fee

• OR higher performance fee

GP Compensation Formula

$$R_{GP}=\left(P_1\cdot r_{m}\right)+\max\left\lbrack0,\left(P_1-P_0\right)\cdot p\right\rbrack$$

r_m = fixed GP management fees as a percentage of assets under management (AUM)

P₀ = beginning-of-period assets

P₁ = end-of-period assets

p = GP performance fee as a percentage of total return

What is the investor return formula after fees?

$$r_{i}=\frac{P_1-P_0-R_{GP}}{P_0}$$

What is the purpose of a high-water mark?

Prevents managers from charging performance fees twice on the same gains.

What is survivorship bias in hedge fund indexes and why is it common?

• failed funds are excluded, overstating average returns

• Many poorly performing funds close and disappear from databases.

What is backfill bias and effect?

• Selectively adding successful historical fund returns to databases after good performance

• artificially inflates reported hedge fund performance.