Alternative Investment Performance and Returns

Investment performance measurement on common asset classes, such as public equity and debt, is relatively straightforward. In alternative investments, there are unique features that make this asset class somewhat complicated when it comes to measurement of investment risk and return. In this learning module, we first discuss these unique characteristics and the challenges they pose to performance appraisal. T hen we explain the various features in the complex fee arrangement in alternative investments and the nuances when it comes to calculating investor returns.

• Alternative investments differ from traditional asset classes in that they involve longer time horizons, unique patterns of cash f lows, the use of leverage, illiquid positions, more complex fee structures, different tax and accounting treatment, and so on. In addition, returns are usually less normally distributed for alternative investments than for traditional investments. 
• The investment life cycle is usually longer and involves three phases: capital commitment, capital deployment, and capital distribution. 
• Internal rate of return (IRR) is often the preferred measure for alternative investment returns. The multiple of invested capital (MOIC) is often used as a shortcut measure, but it ignores the timing of cash f lows.
• Customized and complex compensation arrangements seek to align manager and investor incentives. Special provisions also exist for the lockup and redemption of capital from investors.In addition to a base management fee, alternative investments often charge additional performance fees based on a percentage of periodic fund returns. When calculating fees and investors’ net returns, different features have to be considered, such as founder share class, either/or fee structure, hurdle rate, and high-water mark and clawback clauses.
• It is difficult to generalize performance appraisal for these investments because returns may vary depending on how and when a particular investor invested in a particular vehicle.
• In addition to a base management fee, alternative investments often charge additional performance fees based on a percentage of periodic fund returns. When calculating fees and investors’ net returns, different features have to be considered, such as founder share class, either/or fee structure, hurdle rate, and high-water mark and clawback clauses.
• It is difficult to generalize performance appraisal for these investments because returns may vary depending on how and when a particular investor invested in a particular vehicle.