A Guide to Navigating the Unique Challenges of Performance Appraisal
Measuring the performance of alternative investments is far more complex than for traditional assets like stocks and bonds. This is due to several unique characteristics that complicate standard evaluation methods.
Illiquidity, irregular cash flows, complex fee structures, and valuation challenges make performance measurement particularly difficult for alternative investments.
Alternative investments follow a distinct life cycle:
J-Curve Effect: This life cycle creates a pattern where a fund's net returns are typically negative in the early years before turning positive as investments mature and are harvested.
Because of the J-curve and irregular cash flows, simple time-weighted returns are often inappropriate. Instead, analysts use money-weighted metrics.
Most Common Metric
The IRR is the discount rate that makes the net present value (NPV) of all cash flows (initial investment, contributions, and distributions) equal to zero.
Note: It is the most common measure of performance for private funds, but it is sensitive to the timing of cash flows.
Total Value to Paid-In
Also known as "Total Value to Paid-In" (TVPI), this metric compares the fund's total value (realized distributions + unrealized value) to the total capital invested.
Limitation: Simple to calculate but ignores the time value of money.
Alternative investments are often illiquid and lack public market prices. Their valuation relies on estimates, which are classified into a three-level hierarchy:
Based on quoted prices for identical assets in active markets (e.g., publicly traded stocks).
Based on observable inputs other than quoted prices (e.g., pricing for a similar, more liquid asset).
Based on unobservable inputs and the fund manager's own models ("mark-to-model"). Alternative investments frequently fall into this category.
Impact: Level 3 valuations can lead to smoothed returns and understated volatility.
Leverage is frequently used to amplify returns. The return on a leveraged portfolio depends on the return of the invested assets and the cost of borrowing.
Illustrative Example: Leveraged Return
An investor puts in $40 of their own cash (Vc) and borrows $60 (Vb) at a cost of 5% (rb). The total $100 portfolio earns a return of 10% (r).
Step 1: Calculate the leveraged return
Conclusion:
Leverage amplified the 10% asset return to a 17.5% return on the investor's equity.
The "2 and 20" fee structure and its various clauses (hurdle rates, high-water marks, clawbacks) make it difficult to compare net returns across different funds and even among different investors in the same fund, depending on when they invested.
Hedge funds are private, unregulated investment pools, and their self-reported returns are subject to several biases that can inflate performance.
Upward Bias in Returns
Failed or poorly performing funds stop reporting their results and are excluded from historical databases. This means that the average return of the surviving funds is artificially high, as it doesn't account for the losers.
Selective Reporting
When a new fund is added to a database, it often "backfills" its past performance history. Managers are only incentivized to do this if their past performance was good, which again inflates the historical average of the database.
To protect against mass withdrawals during periods of poor performance, hedge funds use several tools to manage liquidity:
A period after the initial investment during which investors cannot withdraw their capital.
Require investors to give advance notice (e.g., 30-90 days) before a withdrawal.
Limit the amount of capital that can be withdrawn from the fund during any given redemption period.