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Alternative Investment Performance and Returns

Alternative Investments

Alternative Investment Performance

Learning Outcome Statement:

describe the performance appraisal of alternative investments

Summary:

The performance appraisal of alternative investments involves understanding their unique features such as staggered capital commitments, longer investment horizons, reduced liquidity, and less efficient markets. These factors necessitate different appraisal methods compared to traditional asset classes. Key areas of focus include the investment life cycle, use of borrowed funds, valuation methodologies, and complex fee structures.

Key Concepts:

Investment Life Cycle

Alternative investments typically undergo a life cycle consisting of capital commitment, capital deployment, and capital distribution phases. Each phase impacts the timing and magnitude of cash flows, influencing the investment's performance appraisal.

Use of Borrowed Funds

Alternative investments may use leverage to enhance returns. This involves borrowing funds to increase the size of the investment, which can magnify both gains and losses.

Valuation

Valuing alternative investments can be challenging due to their illiquidity and the use of complex models. Fair value measurement often relies on unobservable inputs, making periodic performance comparisons difficult.

Fees

Alternative investments often have complex fee structures that include management fees and performance-based fees. These fees can significantly affect net returns and vary greatly among investors depending on the terms of their investment.

Formulas:

Internal Rate of Return (IRR)

IRR=∑t=0nCFt(1+r)t=0\text{IRR} = \sum_{t=0}^{n} \frac{CF_t}{(1 + r)^t} = 0

IRR is used to evaluate the overall profitability of an investment, accounting for the timing and magnitude of cash flows.

Variables:
CFtCF_t:
Cash flow at time t
rr:
Discount rate
tt:
Time period
nn:
Total number of periods
Units: percentage

Multiple of Invested Capital (MOIC)

MOIC=Realized value of investment+Unrealized value of investmentTotal amount of invested capital\text{MOIC} = \frac{\text{Realized value of investment} + \text{Unrealized value of investment}}{\text{Total amount of invested capital}}

MOIC measures the total value generated by an investment relative to the total capital invested, ignoring the timing of cash flows.

Variables:
RealizedvalueofinvestmentRealized value of investment:
Total cash received from the investment
UnrealizedvalueofinvestmentUnrealized value of investment:
Current market value of remaining investment
TotalamountofinvestedcapitalTotal amount of invested capital:
Initial capital invested minus any fees or expenses
Units: ratio

Leveraged Rate of Return

rL=r+VbVc(r−rb)r_L = r + \frac{V_b}{V_c}(r - r_b)

This formula calculates the rate of return on a leveraged investment, showing how borrowing amplifies the return based on the difference between the investment return and the borrowing cost.

Variables:
rLr_L:
Leveraged rate of return
rr:
Rate of return on the cash position
VbV_b:
Value of borrowed funds
VcV_c:
Value of cash investment
rbr_b:
Borrowing rate
Units: percentage

Alternative Investment Returns

Learning Outcome Statement:

calculate and interpret alternative investment returns both before and after fees

Summary:

This LOS focuses on understanding the calculation and interpretation of returns from alternative investments, considering various fee structures and market conditions. It covers the impact of management and performance fees, lockup periods, redemption fees, and other factors such as high-water marks and hurdle rates on the returns to investors. The content also discusses the implications of fee structures on the net returns and the importance of considering these when evaluating alternative investment opportunities.

Key Concepts:

Management and Performance Fees

Alternative investments often involve complex fee structures that include both management fees (a fixed percentage of assets under management) and performance fees (a percentage of the profits), which can significantly affect the net returns to investors.

Lockup and Redemption Fees

Lockup periods restrict investor withdrawals for a certain time to allow managers to execute strategies without forced liquidations. Redemption fees may be charged to offset transaction costs from withdrawals, impacting investor returns.

High-Water Marks and Hurdle Rates

High-water marks ensure that performance fees are only paid on new profits above the highest previously achieved fund value. Hurdle rates require that a minimum return level be achieved before performance fees are paid, aligning manager incentives with investor interests.

Survivorship and Backfill Bias

These biases in hedge fund indexes can lead to misleading performance data. Survivorship bias occurs when failed funds are excluded from performance calculations, and backfill bias happens when only successful funds' historical data are included.

Formulas:

General Partner's Return

RGP=(P1×rm)+max⁡[0,(P1−P0)×p]RGP = (P1 \times rm) + \max[0, (P1 - P0) \times p]

Calculates the total return to the general partner including both management and performance fees.

Variables:
RGPRGP:
Return to the general partner
P1P1:
End-of-period assets
P0P0:
Beginning-of-period assets
rmrm:
Management fee rate
pp:
Performance fee rate
Units: currency

Investor's Periodic Rate of Return

ri=(P1−P0−RGP)P0ri = \frac{(P1 - P0 - RGP)}{P0}

Determines the investor's rate of return after accounting for the total fees paid to the general partner.

Variables:
riri:
Investor's rate of return
P1P1:
End-of-period assets
P0P0:
Beginning-of-period assets
RGPRGP:
Return to the general partner
Units: percentage
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