Performance and Returns Flashcards
Alternative investments are customized investments whose distinctive features complicate performance appraisal between investments and across asset classes. Which features are these?
The timing of cash inflows and outflows for specific investments.
The use of borrowed funds.
The valuation of individual portfolio positions over specific phases of the investment life cycle.
More complex fee structures and tax and accounting treatment.
What are four areas to focus on when appraising alternative investments?
Investment life cycle
Amount of borrowed funds used
Valuation of assets
Fee structure of the fund
Describe the three distinct phases of an alternative investment life cycle.
Capital commitment (mostly cash outflows because of capital investment and fees)
Capital deployment (still mostly outflows because of fees, managers are deploying the money in the investments here)
Capital distribution (when the investments pay off, the fund returns accelerate and it is mostly inflows)
This curve is the J-curve.
How to calculate investment returns for investments following a J-curve (such as private equity and real estate) and why?
Internal rate of return, because it takes into account the respective cash flows into an investment and the timing thereof, versus the magnitude and the timing of the cash flows returned by the investment. (Using WACC)
Why is the MOIC preferred over IRR?
The IRR involves assumptions regarding the opportunity cost of outgoing cash flows and the reinvestment rate for incoming cash flows will affect the results.
What is the MOIC?
Multiple of Invested Capital, or Money Multiple, on total invested capital.
It is calculated by dividing the total value of all realized investments and residual asset values by the initial total investment (which is paid-in capital minus fees and expenses).
Although MOIC ignores the timing of cash flows, it is easier to calculate, and it is intuitively easier to understand when someone says he received two or three times his initial investment.
The use of leverage can increase the leveraged return in good times but also increase the leveraged loss in bad times! Hedge funds often use leverage through derivatives or borrowing capital from prime brokers.
Describe a typical margin financing between a hedge fund and a prime broker?
The prime broker essentially lends the hedge fund the shares, bonds, or derivatives, and the hedge fund deposits cash or other collateral into a margin account with the prime broker based on certain fractions of the investment positions. The margin account represents the hedge fund’s net equity in its positions. The minimum margin required depends on the riskiness of the investment portfolio and the creditworthiness of the hedge fund.
Alternative assets are often characterized by illiquidity, which makes performance appraisal over time challenging and periodic comparison with common asset classes difficult. Accounting rules dictate that investments must be recorded at their fair value for financial reporting purposes.
What is the fair value of an investment?
A market-based measure based on observable or derived assumptions to determine a price that market participants would use to exchange an asset or liability (exit price) in an orderly transaction at a specific time.
Describe the three-level hierarchy to measure fair value.
Level 1, quoted prices in active markets for identical asset/liability that may be accessed as of measurement date.
Level 2, inputs other than quoted market prices in level 1 that are directly or indirectly observable for an asset/liability, such as implied volatility.
Level 3, unobservable inputs are used to measure fair value for asset/liability in which there is little, if any, market activity as of the measurement date.
The lack of market information for alternative investments causes the fair value to be determined at level 3 to be very difficult. Therefore, the initial costs are often chosen, with adjustments to carrying value when impairments occur. This gives investors a false sense that they are less correlated with and less volatile than other investments, although a more realistic picture may emerge if managers are forced to liquidate a portfolio prematurely.
For level 3 asset pricing, regardless of the model used, the model should be independently tested, benchmarked and calibrated to industry-accepted standards to ensure a consistency of approach.
Hence, every investment vehicle that is heavily involved with Level 3 priced assets deserves increased scrutiny and due diligence.
Alternative investment fees also vary from those for common asset classes, which typically involve a flat management fee. Alternative investment often levy additional performance fees based on a percentage of periodic fund returns.
Hedge funds often use complex strategies to achieve outsized returns with low correlation with the broader market. These more complex strategies require more sophisticated portfolio management tools and a larger range of skills, making them more expensive to run. Rather than paying a very high flat management fee, investors demand that some of the compensation is aligned to the performance delivered by the strategy in the form of a performance fee.
Apart from the performance fee, there are also other customized, complex compensation arrangements that seek to align manager and investor incentives. These structures are designed to reward investors for early involvement, larger investments, and/or longer lockup periods. Another factor that can lock in or magnify losses for hedge funds is investor redemptions. Redemptions frequently occur when a hedge fund is performing poorly. Redemptions may require the hedge fund manager to liquidate some positions and potentially receive particularly disadvantageous prices when forced to do so by redemption pressures, while also incurring transaction costs.
Describe the redemption function that investors have.
Redemptions occur when a hedge fund is performing poorly. They may require the hedge fund manager to liquidate some positions and potentially receive some disadvantageous prices when forced to do so by redemption pressures. Funds sometimes charge a redemption fee to discourage redemption and to offset the transaction costs for remaining investors in the fund.
What is a notice period and a lockup period for hedge funds?
A notice period is a period in advance that investors may be required to notify a fund of their intent to redeem some or all of their investment. This notice period allows the fund manager an opportunity to liquidate a position in an orderly fashion without magnifying the losses. A lockup period is the minimum holding period before investors are allowed to make withdrawals or redeem shares from a fund. This provision is intended to allow the hedge fund manager the required time to implement and potentially realize a strategy’s expected results.
What is a gate for hedge funds?
Funds sometimes impose a gate, which is a provision that when implemented limits or restricts redemptions for a period of time, usually at the discretion of the fund manager.
A hedge fund’s ability to demand a long lockup period while raising a significant amount of investment capital depends a great deal on the reputation of either the firm or the hedge fund manager. Ideally, redemption terms should be designed to match the expected liquidity of the assets being invested in, but even with careful planning, an initial drawdown can turn into something far more serious when it involves illiquid and obscure assets.
What are examples of custom fee arrangements?
Fees based on liquidity terms and asset size; longer lockups/larger investments result in lower fees.
As a way to entice early participation in startup funds, managers sometimes offer incentives known as founders class shares, which gives early investors a lower fee structure.
Either/or fees; investors can choose between fixed management and variable performance fees
What is survivorship bias in hedge funds?
The exclusion of failed funds from a given benchmark is a form of selection bias that can lead to overly optimistic return expectations from a hedge fund benchmark.
