ALTERNATIVE INVESTMENTS

MODULE 77.1: PERFORMANCE APPRAISAL AND RETURN CALCULATIONS

1. **Cashflow Lifecycle for Alternative Investments: **
   • Capital Commitment Phase: Partners and Investors promise to commit a amount and startup makes "capital calls (give us the money)".
   • Capital Deployment Phase: Startup is investing and conquering the market aggressively. ROI is negative.
   • Capital Distribution Phase: ROI turns positive. Investors earn dividends.
2. The above life-cycle is characterised by J-curve. Start from 0, do gown and then steeply climb upwards.
3. Given the variability of cash flows over a fund's life and the importance of management decisions in the timing and magnitude of after-tax cash flows, an IRR over the life of a fund is the most appropriate measure of after-tax investment performance.
4. A simpler measure of investment success�is the multiple of invested capital (or money multiple)�- the ratio of total capital returned plus the value of any remaining assets, to the total capital paid in over the life of the investment.
5. Suppose I have \(V_0\) and I borrow \(V_B\) at rate \(r_b\). I make \(r\) on my total investment.
   • My net return: Money I made - Money I owe (b/c I borrowed) = \(r \times (V_0 + V_B) - r_b \times V_B\)
   • My leveraged return would be: $$ r_L = \frac{rV_0 + (r-r_b)V_B}{V_0} $$
6. Alt Investments are usually illiquid. Asset Valuations occur using the fair value hierarchy:
   • Level I: Liquid and trades frequently
   • Level II: Illiquid but valuation can be estimated using tradeable derivatives and other observable inputs. For example: A corporate bond might not trade on exchange but you can value it using the spread on similar bonds (or some bond index).
   • Level III: Extremely Illiquid
7. Particularly for Level 3 investments, the absence of market activity can result in valuations that remain near their initial cost for long periods. As a result, these values might not reflect the actual exit costs of the investments.
8. Importantly, this relative lack of change in fair values can make reported returns for alternative investments appear higher, less risky, and less correlated with traditional investments than they really are. Even if a startup is losing money, the valuation sticks to the cost value of its assets.
9. Survivorship bias happens when performance data shows only funds that are still alive, making results look better than they really were; example: 100 hedge funds start in 2020, 30 fail after losing money, but the index tracks only the surviving 70, so investor losses in the failed funds disappear from the numbers.
10. Backfill bias happens when funds enter databases only after doing well and then report their good past returns; example: a fund launches in 2021, makes +20% in its first year, joins a database in 2022, and adds that +20% to its history, while funds with bad starts never get included.
11. Vintage year means comparing funds that started in the same year so they are at similar stages of life; example: comparing 2018 funds with other 2018 funds is fair, but comparing a new fund with one that started in 2005 mixes early growing pains with mature performance and misleads.
12. Management fee is a fixed annual fee charged on assets under management, paid regardless of performance; example: a fund with INR 100 crore AUM charging 2% earns INR 2 crore per year even if returns are zero or negative.
13. Hurdle rate is the minimum return the fund must earn before performance fees apply; example: with an 8% hurdle, a fund earning 6% pays no performance fee, but earning 12% pays fees only on the excess above 8%.
14. Performance fee is a share of profits taken by the manager after crossing the hurdle; example: with a 20% performance fee, if a INR 100 investment earns INR 20 above the hurdle, the manager keeps INR 4 and investors keep INR 16. It cannot be negative.

a. An American-style (deal-by-deal) waterfall structure b. A European-style (whole-of-fund) waterfall structure

MODULE 79.1: REAL ESTATE

1. Real estate investing is just two questions:
   1. Am I lending money or owning the building? → Debt vs Equity
   2. Is it privately negotiated or market-traded? → Private vs Public
2. PRIVATE + DEBT → You lend directly to property projects:
   • Mortgage debt – senior loan on finished property
   • Construction loans – fund the build phase
   • Mezzanine debt – sits between debt & equity (high risk, high coupon)
3. PRIVATE + EQUITY
   • Sole ownership: You alone own the property, take all risk, get all cash flows.
   • Joint ventures: Multiple parties pool capital/skills to own a property and split returns by contract.
   • Limited partnerships: Passive investors fund the deal; a general partner runs it and takes performance fees.
   • Private real estate funds: Pooled private capital managed by a fund manager to buy/sell properties across deals.
   • Private REITs: Non-listed REITs that own income-producing real estate but trade privately, not on exchanges.
4. PUBLIC + DEBT
   • Covered bonds: Bank bonds backed by mortgages that stay on the bank’s balance sheet as collateral.
   • Mortgage REITs: Companies that borrow cheaply and invest in mortgage securities to earn the spread.
   • Mortgage ETFs: Exchange-traded funds that simply hold baskets of mortgage bonds or mortgage REITs.
5. REITs that pursue core real estate strategies invest in high-quality commercial and residential properties that deliver stable returns.
6. Core-plus real estate strategies, which accept a bit more risk than core strategies by undertaking modest development and redevelopment.
7. Value-add real estate strategies, which undertake development and redevelopment on a somewhat larger scale than core-plus strategies.
8. Opportunistic real estate strategies, which pursue large-scale redevelopment and repurposing of assets, invest in distressed properties, or speculate on upturns in real estate markets.

PRIVATE EQUITY

1. Each private equity fund has a vintage year, which is the year the fund made its first investment. The performance of a fund is greatly influenced by its vintage year and the phase of the business cycle in that year. Funds that begin investing during a business cycle expansion are likely to earn higher rates of return if they specialize in early-stage companies. Funds that begin investing during business cycle contractions are likely to earn higher rates of return if they specialize in distressed companies. Investors in private capital should diversify across vintage years.