8.2 Alternative Investment performance and returns

Question 1

assessing the performance of investments in alternative assets can be complicated by the following factors:

Answer 1

Lags between the timing of when capital is committed, when it is actually invested, and when redemptions are received.

The impact of leverage

Differences in methods used to value different types of positions or the same positions over the course of their investment horizon

Complex fee structures and tax considerations

Question 2

Four key issues to consider when assessing the performance of alternative investments

Answer 2

the investment life cycle

the use of borrowed funds

asset valuation methods

fees.

Question 3

While the life cycles of investments in different types of alternative assets differ, they tend to follow the same general three-stage pattern:

Answer 3

Capital commitment

Capital deployment

Capital distribution

Question 4

Capital commitment

Answer 4

When a fund is launched, investors make capital commitments that are drawn upon (or called) by the manager as investment opportunities arise.

The negative outflows in early years are exacerbated by the convention of calculating management fees based on committed capital rather than called capital or assets under management.

Question 5

Capital deployment

Answer 5

Negative returns continue during the beginning of this phase as additional investments are made and management fees continue to be charged.

However, the net rate of cash of outflows slows as inflows begin to accumulate from investments that were made in the previous phase.

By the end of this phase, inflows are roughly equal to outflows.

Question 6

Capital distribution

Answer 6

While more investments continue to be made, the level of outflows is significantly lower than what was needed during the previous phases.

While the level of inflows gradually declines, net cash flows are positive for investors throughout this longest phase of the cycle.

Investors receive a final distribution when all positions have been liquidated.

Question 7

J-curve effect

Answer 7

A typical private equity investment vehicle exhibits a J-curve effect over the course of its life, with negative cash flows over an initial number of years followed by years of net inflows

Real estate funds follow a similar pattern with substantive cash outlays needed to purchase and upgrade improvements, followed by years of net inflows from contractual rent payments and property sales

Question 8

The internal rate of return (IRR)

Answer 8

a key metric in evaluating the performance of private equity and real estate investments.

Its calculation is affected by the timing and magnitude of the cash inflows and cash outflows, which is fair given that managers have discretion over these factors

However, a drawback of the IRR measure is that it is based on certain assumptions about a financing rate for outgoing cash flows and a reinvestment rate for incoming cash flows.

Question 9

multiple of invested capital (MOIC) metric

Answer 9

also known as the money multiple on total paid-in capital (paid-in capital less management fees and fund expenses)

MOIC measures the total value of all distributions and residual asset values relative to an initial total investment.

While this is an intuitive metric that has the advantage of simplicity relative to IRR, it completely ignores the timing of cash flows.

Question 10

multiple of invested capital (MOIC) formula

Answer 10

MOIC = (Realized value + Unrealized value of investment) / Total amount of investment

Question 11

Assets can be classified into the following categories for valuation purposes:

Answer 11

Level 1 assets

Level 2 assets

Level 3 assets

Question 12

Level 1 assets

Answer 12

traded on a public exchange.

These quoted prices should be used whenever they are available.

Question 13

Level 2 assets

Answer 13

valued based on quotes from brokers if a Level 1 pricing is unavailable.

When valuing these assets, it is common for funds to base their valuations on the average of the bid and ask prices.

However, the more conservative and theoretically accurate approach is to use the bid prices for long positions and ask prices for short positions.

Question 14

Level 3 assets

Answer 14

valued using internal models if a Level 2 pricing is unavailable.

Investors should scrutinize these valuations because they are based on estimates rather than observable transaction prices.

Ideally, the models used for valuations of this nature will be independently tested and calibrated to acceptable standards.

However, “mark-to-model” pricing produces more theoretical valuations rather than true liquidation values and can lead to smoothed valuations that overstate returns and understate a portfolio’s volatility.

Question 15

The vehicles that are commonly used for investing in alternative assets are typically designed to meet the following objectives:

Answer 15

1. The return of capital to investors
2. A minimum level of return on capital (i.e., hurdle rate)
3. Performance-based compensation for managers if the first two objectives are achieved

Question 16

Common restrictions on withdrawals include:

Answer 16

Redemption fees to offset the transaction costs incurred on sales needed to meet redemption requests.

Notice periods that give managers a greater opportunity to liquidate positions in an orderly manner.

Lockup periods during which investors are prohibited from making any withdrawals, even with advance notice.

Liquidity gates that establish limits the amount that investors may withdraw during a specified period.

Question 17

Other than the most commonly quoted fee structures of “2 and 20” and “1 and 10”, variations of fee arrangements include:

Answer 17

1. Fees based on liquidity terms and asset size
2. Founder’s shares
3. “Either/or” fees

Question 18

Fees based on liquidity terms and asset size

Answer 18

Hedge funds may charge lower fees to larger investors or investors who are willing to accept longer lockup periods.

Funds with strong performance records and capacity constraints are often in a position to turn down new, larger investors seeking preferential fee arrangements in side letter agreements.

Question 19

Founder’s shares

Answer 19

Founders’ shares are used to entice early participation in start-up and emerging hedge funds.

They entitle investors to a lower fee structure.

These shares are typically available to investors who contribute before a certain cutoff threshold, such as the first $100 million in assets.

Question 20

“Either/or” fees

Answer 20

It has become increasingly common for large institutional investors to deviate from the traditional 2 and 20 fee structure by requiring a fee structure in which the manager’s annual compensation is the greater of (1) a relatively low management fee (e.g., 1%), or (2) a relatively high performance fee (e.g., 30%) on returns in excess of a mutually agreed-upon annual hurdle rate.

This fee structure is designed to reward performance and delivery of true alpha above a benchmark.

Question 21

Relative Alternative Investment Returns and Survivorship Bias with Hedgefunds

Answer 21

Most hedgefunds usually fail within 3 years, creating survivorship bias when we calculate average performance for standing hedgefunds

Another concern with hedge fund indexes is backfill bias, which occurs when funds are only added to an index after an initial period of success. Index returns do not reflect the impact of funds that never achieved the level of success needed to meet the requirements for inclusion.

Because of this selectivity, hedge fund indexes tend to reflect the performance the most successful funds rather than being broadly representative of the overall asset class.