Alternative Investment Performance and Returns

A headline return on an alternative investment can mean very different things depending on how it was measured, what the fund borrowed, how its assets were valued and which fees were taken. This module walks through the life cycle of a private fund, the limits of standard risk-adjusted measures, the use of IRR and multiples, the effects of leverage, redemptions and valuation, and the step-by-step conversion of gross returns into what investors actually keep.

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What you will learn

1. Describe the life cycle of a private alternative investment fund and explain why appraising the performance of alternative investments requires measures beyond the Sharpe ratio.

Life cycle: commitment and deployment, value creation, then harvesting and distributions; typical fund life 10-12 years.
The J-curve: early net returns are negative because fees and costs come before gains are realized.
Smoothed valuations, non-normal returns and biased data make standard statistics unreliable.
The Sharpe ratio misses tail risk in negatively skewed strategies; Sortino uses downside deviation instead.
Calmar (and MAR) ratio = compound annual return divided by maximum drawdown.

2. Calculate and interpret the internal rate of return and the multiple of invested capital for private investments, and explain when time-weighted returns are more appropriate.

IRR is the discount rate that sets the NPV of calls, distributions and ending NAV to zero; it is a money-weighted return.
MOIC = (realized value + unrealized value) / invested capital; it ignores the time taken.
High IRR with low MOIC suggests a quick exit; lower IRR with high MOIC suggests a longer, compounding hold.
Delaying capital calls (for example with subscription lines) can raise IRR without changing the multiple much.
Use IRR when the manager controls cash flows (private equity); use TWR when investors control them (hedge funds).

3. Explain how leverage, redemption terms, valuation practices and custody arrangements affect the returns of alternative investments, and calculate returns on levered positions.

Levered return = [r(Vc + Vb) - rb x Vb] / Vc; leverage magnifies both gains and losses.
Leverage helps only when the return on the position exceeds the borrowing cost; margin calls can force sales.
Lockups, notice periods, redemption fees, gates and side pockets protect remaining investors from forced selling.
Level 3 (model-based) valuations rely on judgment and produce smoothed, possibly stale returns.
Independent custody and administration guard against fraud and misvaluation.

4. Calculate the net-of-fee returns of alternative investment funds given the management fee basis, the performance fee basis, hurdle rates and high-water marks.

Always identify the management fee basis (beginning or ending AUM, or committed capital).
A performance fee calculated net of the management fee is lower than one calculated independently.
Hard hurdle: fee on the excess over the hurdle; soft hurdle: fee on the whole gain once the hurdle is beaten.
High-water mark: performance fee only on value above the previous fee-paying peak.
Net return = (gross ending value - management fee - performance fee) / beginning AUM - 1.

Module at a glance

Private funds move through commitment, deployment, value creation and harvesting; early fees create the J-curve.
Smoothed valuations and negatively skewed returns make the Sharpe ratio unreliable; use Sortino and Calmar as well.
IRR is money-weighted and timing-sensitive; MOIC shows the multiple but ignores time; read them together.
Use TWR when investors control the cash flows (hedge funds) and IRR when the manager does (private equity).
Levered return = [r(Vc + Vb) - rb x Vb] / Vc; leverage magnifies gains and losses.
Gates, lockups and side pockets protect remaining investors; Level 3 valuations depend on judgment.
Net return depends on the fee bases, the hurdle type and the high-water mark: calculate each step explicitly.

This free module has 4 lessons, 13 practice questions with full explanations.

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