ALT 2 Alternative Investment Performance and Returns

Measuring performance on public equity and public debt is comparatively simple. Alternative investments carry a set of distinctive features, longer horizons, unusual cash flow patterns, leverage, illiquid positions, more elaborate fee terms, and different tax and accounting treatment, that make risk and return far harder to pin down. Their returns also tend to be less normally distributed than those of traditional assets, so the usual risk measures fit them poorly.

Public securities are easy to compare because they are standardized claims: buying one requires no further capital commitment, every holder receives identical periodic cash flows (dividends for shareholders, contractual coupons and principal for bondholders), prices are quoted more or less continuously, large peer groups exist, and widely accepted indexes serve as benchmarks. Alternatives are customized instead, and four features in particular complicate any appraisal:

• The exact sequence of when money flows into and out of a given holding.
• The amount of borrowed money used to hold the position.
• The valuation of individual holdings across the phases of the investment life cycle.
• More complex fee arrangements together with differing tax and accounting treatment.

Three phases and the J-curve

An alternative investment generally moves through three distinct phases, each dominated by a characteristic pattern of cash flows:

• Capital commitment. The manager selects investments and draws capital through capital calls, whether an early-stage company for venture capital, a maturing firm for private equity, or properties for real estate. Returns are usually negative here because fees and expenses arrive immediately while the assets produce little or no income.
• Capital deployment. Funds are put to work, on construction and improvements for real estate or infrastructure, on turnaround costs for a mature company, or on launching a startup. Cash outflows typically exceed inflows, and management fees reduce returns further.
• Capital distribution. Once the strategy succeeds, assets appreciate or generate income above costs, and returns accelerate. The fund may realize large gains on exit, through an IPO for venture capital or property sales for real estate.

Plotting cumulative return against time traces the letter J: an early dip in the commitment phase, a climb through deployment, and a levelling off as capital is returned and the fund winds down.

IRR and the MOIC shortcut

Because these cash flows are staggered and often hard to anticipate, the internal rate of return (IRR) is the preferred starting point for private equity and real estate returns: it weighs both the size and the timing of every cash flow, rewarding or penalizing the manager for timing decisions that are genuinely at the manager’s discretion. IRR does require assumptions, a financing rate for money paid out (often the weighted average cost of capital) alongside a reinvestment rate for money coming back that may never actually be earned, but it remains the key long-term metric. The IRR solves for the rate that sets the present value of all cash flows to zero:

A simpler alternative that many managers quote is the money multiple, formally the multiple of invested capital (MOIC). It compares the total value created against the capital actually put to work, defined as paid-in capital after management fees and fund expenses are removed:

MOIC is intuitive, saying you doubled or tripled your money is easy to grasp, but it ignores timing entirely. Doubling your money in two years is excellent; taking fifteen years to do the same is not. During the middle years of a fund, interim accounting values also matter less, since no cash flows hinge on them and long-lived holdings are often carried near cost until a clear impairment or realization event occurs.

Borrowed funds let an investor hold a position larger than the capital committed, which magnifies both gains and losses. Take a cash position of value V_c earning periodic return r. If the investor borrows an additional V_b at a periodic cost r_b, the leveraged return r_L on the cash actually put up is:

Rearranging shows the magnification effect directly, as a spread term added to the unlevered return:

Leverage adds to the return whenever the asset return exceeds the borrowing cost and subtracts from it whenever the asset return falls short. Hedge funds obtain leverage through derivatives or by borrowing from prime brokers, negotiating margin, interest, and fees in advance; the margin account holds the fund’s net equity in its positions. If that equity slips below a threshold, the lender issues a margin call for more collateral. A fund unable to meet the call may be forced to liquidate a losing position, and a large forced sale can move the price against the fund, locking in or deepening the loss.

Fair value and the three-level hierarchy

Illiquidity makes valuation the other appraisal headache. Accounting rules require investments to be carried at fair value, a market-based estimate of the price at which participants would exchange the asset in an orderly transaction, often the exit price for a seller. The inputs used follow a three-level hierarchy.

Traditional assets lean on Level 1 inputs, but private equity, real estate, and similar holdings often rely on Level 3. With no fresh market data, their carrying values may sit near cost for long stretches, which can make them look less volatile and less correlated than they truly are, until a forced sale reveals otherwise. Any such model should be independently checked, benchmarked, and calibrated against accepted industry standards, and hedge funds must document and consistently apply their in-house valuation procedures. Because mark-to-model figures reflect theory rather than a true liquidation value, returns may be smoothed or overstated and volatility understated, so heavy Level 3 exposure warrants extra scrutiny.

Traditional funds usually charge a flat management fee. Alternatives layer on a performance fee tied to a percentage of periodic returns, which aligns the manager with results but makes appraisal hard to generalize: two investors in the same fund can earn different net returns depending on how much they committed and when. An investor who commits more capital early, or accepts tighter redemption terms, often pays lower incentive fees. And an investor who enters after a sharp drop may pay a performance fee on the recovery, while an earlier investor who suffered the fall may owe nothing for the same period.

Liquidity terms that shape fees

Several provisions govern when investors can pull capital out, and they interact with fees:

• A redemption fee discourages withdrawals and offsets the transaction costs borne by remaining investors.
• A notice period, typically 30 to 90 days, requires advance warning of intent to redeem, giving the manager time to unwind positions in an orderly way.
• A lockup period is the minimum holding time before any withdrawal is allowed, giving a strategy time to play out.
• A gate limits or suspends redemptions for a period, usually at the manager’s discretion.

Redemptions tend to cluster when a fund is doing poorly, forcing sales at disadvantageous prices and adding transaction costs, so these terms exist to protect remaining investors. A manager’s ability to demand a long lockup while still raising capital depends heavily on the reputation of the firm or the individual. Funds of hedge funds can often offer more redemption flexibility than direct investors receive, thanks to special arrangements with underlying managers, extra cash reserves, bridge financing, or simply avoiding the least liquid strategies.

Custom fee arrangements

Managers tailor fees to reward early, larger, or longer-committed investors:

• Liquidity terms and asset size. Longer lockups and larger commitments earn discounts. For large limited partners, management fees may fall anywhere between 0.5% and 1.5%, while incentive fees drop toward the 10% to 15% band. Small, strong-performing funds with capacity limits, by contrast, may keep high fees and even turn away large investors.
• Founders shares. To attract early money, a startup fund may offer a founders class, say a 1.5% management fee and 10% performance fee in place of the standard 2% and 20%, sometimes applying only to the first $100 million raised or until the fund hits a size or performance target.
• Either/or fees. Large institutions have pushed funds to accept an either/or agreement: the manager accepts either a reduced 1% management fee that covers costs through weak years or an elevated 30% incentive fee above an agreed hurdle in strong years, taking whichever proves larger. Smaller investors typically face more traditional fixed terms.

The either/or structure is easiest to see across several years. Suppose a closed-end infrastructure fund starts with €100 million and lets the GP take either a 1% management fee or a 25% incentive fee, whichever is greater, with a standard high-water mark. In loss years only the management fee is available; once the fund clears its prior high-water mark, the 25% incentive fee on the gain typically dominates the small management fee.

Return calculations depend on the exact fee terms. Write the management fee rate as r_m, beginning assets as P₀, ending assets as P₁, and the performance fee as p, a percentage of total return. When the two fees are computed independently, the GP’s currency return R_GP and the investor’s return r_i are:

Charging the performance fee on the return net of the management fee lowers the base and therefore the fee, lifting the investor’s return:

Hurdle rates and high-water marks

Two common modifications reduce performance fees. A hard hurdle rate r_h charges the fee only on returns above the hurdle; a high-water mark P_HWM, the highest after-fee value reached in any prior period, charges the fee only on new gains above that peak. With a hard hurdle net of the management fee:

With a high-water mark, using period-2 values as an illustration:

Timing is what makes the high-water mark investor-specific. A hard hurdle reduces every investor’s fee by the same amount, P_t × r_h × p, but a high-water mark depends on the peak each investor personally reached. A newcomer who buys in at the end of Year 2, when Kettleside is worth $108.9 million, faces that entry value as the mark. In Year 3, with the fund at $128 million, that investor’s performance fee is charged on 128 × 0.99 − 108.9 = 17.82, giving R_GP = 1.28 + 17.82 × 0.20 = $4.85 million and a return of (128 − 108.9 − 4.85) / 108.9 = 13.09%. The original investor, protected by the higher $122.96 million mark, paid a smaller fee and kept a larger 15.67%.

Private capital funds split profits through a distribution waterfall. Limited partners (LPs) first receive their capital back and a preferred return; the general partner (GP) then takes carried interest, a share (commonly 20%) of profits above that preferred return. Several provisions govern exactly how the split is computed.

• A soft hurdle lets the GP earn carried interest on the entire gain once the preferred return is met, usually reached through a catch-up.
• A hard hurdle restricts carried interest to profits above the preferred return only, with no catch-up.
• A catch-up pays the GP first, after the preferred return, until the GP has received its target percentage of total profits.
• A clawback forces the GP to return previously collected carry if later losses pull aggregate profits below what those fees assumed.
• An American (deal-by-deal) waterfall pays carry on each realized deal; a European (whole-of-fund) waterfall pays carry only after the entire fund clears its hurdle.

Investors often judge alternatives on relative returns, comparing a fund against a benchmark of similar investments. That comparison needs care. A composite benchmark can mislead when one fund happens to sit in a later or earlier phase than the bulk of the group, so it is safer to compare funds that share a vintage year, measured annually or from inception onward. Lockups and illiquidity also limit an investor’s ability to react to weak performance by selling.

Funds of hedge funds add a second layer of fees. That double fee is a real drag, but it can still be worth paying: underlying fund returns are rarely identical, so the diligence and diversification a fund of funds provides have value, and it may be the only way into a hedge fund that is closed to new direct investors.

Survivorship and backfill bias

Hedge fund indexes deserve extra scrutiny because their membership shifts over time. More than a quarter of hedge funds fail within their first three years, and dropping those failures from an index produces survivorship bias, an overly optimistic picture built only from funds still standing. A related distortion, backfill bias, arises when a manager launches several funds, then adds only the most successful to an index a couple of years later and backfills its earlier returns. Both biases push reported index returns upward, so a hedge fund index may reflect the winners rather than the true average.