Core Flow

1. Alternative investment performance appraisal is harder than public-stock or public-bond appraisal because the cash flows, valuations, leverage, fees, taxes, and investor terms are not standardized.
2. Public securities are easier to compare because they have quoted prices, similar claims, regular cash flows, and broad benchmarks. Alternative investments are customized, so two investors in the same hedge fund can earn different net returns if they entered at different times or negotiated different fee terms.
3. The four big appraisal complications are the investment life cycle, borrowed funds, valuation, and fee structure. Higher fees alone are not the main point; complex fee arrangements are the main point.
4. Alternative returns are often less normally distributed than traditional returns. Do not blindly trust average return and standard deviation when the strategy has illiquidity, leverage, and ugly left-tail events.
5. The alternative investment life cycle usually has three phases: capital commitment, capital deployment, and capital distribution. Capital commitment means investors promise money; capital deployment means the manager actually puts it to work; capital distribution means cash comes back from income, exits, sales, or liquidations.
6. Early returns are often negative because fees and expenses start before assets produce income. During deployment, cash outflows usually exceed inflows. During distribution, successful assets finally generate cash or are sold.
7. The J-curve means returns first dip negative, then accelerate, then level off as assets are distributed and the fund closes. Memorize it as: fees first, work second, harvest last.

IRR and MOIC

1. Internal rate of return, or IRR, is the preferred measure for many long-lived alternatives because it considers both the amount and timing of cash flows. - What is internal rate of return: the discount rate that makes the present value of all cash inflows and outflows equal to zero. - Why IRR is used: the private equity or real estate manager controls when capital is called and when proceeds are distributed, so timing is part of performance.
2. IRR is useful but not innocent. It requires assumptions about the financing rate for outgoing cash flows and the reinvestment rate for incoming cash flows.

1. Multiple of invested capital, or MOIC, is a shortcut money multiple. It tells you how many times invested capital came back, but it ignores timing. Total invested capital means paid-in capital less management fees and fund expenses. MOIC formula:

1. Realized value means value already received from exits, sales, or distributions. Unrealized value means value still sitting inside the fund.

1. The fund turned €675 million of actual invested capital into €1,500 million of realized plus unrealized value. The timing of those cash flows is invisible inside MOIC.

Leverage

1. Leverage means using borrowed money or derivatives to take a larger market position than the investor’s own capital would allow.
2. Leverage magnifies both gains and losses because the asset return is earned on the full position, while the investor’s own capital absorbs the residual result after borrowing cost.
3. Leveraged return formula:

Shortcut formula:

$$ r_L=r+\frac{V_b}{V_c}(r-r_b) $$ \(r_L\) is leveraged return, \(r\) is underlying asset return, \(V_c\) is investor cash capital, \(V_b\) is borrowed capital, and \(r_b\) is borrowing rate.

1. The whole formula lives inside \(r-r_b\). If the asset return is above the borrowing rate, leverage helps. If the asset return is below the borrowing rate, leverage hurts.

1. A margin account represents the hedge fund’s net equity in its financed positions. A margin call happens when the equity or collateral falls below the required level and the lender demands more collateral.
   • What is margin account: the running account that shows how much of the financed position is still truly yours after borrowing is considered.
   • What is equity: your own leftover stake in the position after subtracting what you owe the lender.
   • What is collateral: cash or securities you post as protection for the lender, so the lender has a buffer if the trade goes bad.
   • Why is margin call used: the lender wants the cushion restored before losses become so large that the loan is no longer safely covered.
   • Think of it like buying a apartment with borrowed money. The apartment value is the full position, the home loan is the borrowing, and your equity is the part of the apartment that is still really yours. If the apartment price falls too much, the bank wants more cushion.
2. Margin calls can lock in losses because the fund may be forced to sell losing positions at bad prices, especially if the sale itself pushes the market price lower.

Valuation

1. Valuation is difficult because many alternative assets are illiquid and do not have clean market prices.
2. Fair value is the market-based price that market participants would use to exchange an asset or liability in an orderly transaction at the measurement date. The seller’s version is often called the exit price.
3. Fair value Level 1 means quoted prices in active markets for identical assets, such as a listed public stock’s closing price.
4. Fair value Level 2 means observable inputs other than Level 1 quoted prices, such as an over-the-counter interest rate derivative priced using observable market data.
5. Fair value Level 3 means unobservable inputs, usually for assets with little or no market activity, such as private equity or real estate valued through cash-flow projection models.

1. Mark-to-model valuation means the value comes from a model rather than a live market price. Models should be independently tested, benchmarked, and calibrated because the manager may have a conflict of interest.
2. Level 3 values can smooth or overstate returns and understate volatility and risk. The asset is not necessarily safer; it may simply be marked less directly.

Fee Structures

1. Gross return is what the fund earns before fees. Net return is what the investor keeps after fees.
2. A management fee is a fixed fee, often based on assets under management or end-of-period value. A performance fee is based on investment gains, often above a hurdle or high-water mark.
3. Different investors in the same fund can face different net returns because of larger commitments, earlier entry, founder share classes, side terms, high-water marks, or longer lockups.
4. Founders shares are lower-fee shares offered to early investors in a new fund. Example: 1.5% management fee and 10% performance fee instead of 2% and 20%.
5. Either/or fees let the manager take either a management fee or an incentive fee, whichever is higher. A large institution may negotiate 1% management fee or 30% incentive fee above a hurdle, whichever is greater.
6. Redemption fee discourages withdrawals and helps offset transaction costs. Notice period is advance warning before redemption, often 30 to 90 days. Lockup period is the minimum holding period before withdrawal. A gate limits redemptions for a period.

1. Basic general partner fee formula when management and performance fees are calculated independently:

1. Investor return after fees:

1. Notation in simple language: \(R_{GP}\) is total manager fee, \(P_0\) is beginning fund value, \(P_1\) is ending fund value before fees, \(r_m\) is management fee rate, \(p\) is performance fee rate, and \(r_i\) is investor net return.
2. Kettleside Timberland is the running example fund here. It starts with USD 100 million, charges a 1% management fee on year-end assets, and takes a 20% performance fee.

1. If performance fee is calculated net of management fee, the formula becomes:

1. A hard hurdle is the investor saying: “You do not earn bonus just because the fund made money. First clear my minimum required return.” Only the return above that hurdle is exposed to performance fee. With a hard hurdle calculated net of management fee:

1. A high-water mark is the previous best fund value after fees. It is the investor saying: “Do not charge me a victory bonus for merely recovering from your old mistakes.”
2. So the rule is simple: after a bad year, the manager can still collect management fee, but performance fee starts again only after the fund rises above the old peak. The formula is:

1. Exam trap: the same fund and same gross Year 3 performance produced 15.39% for the old investor and 12.86% for the new investor because their high-water marks differed.

1. A clawback provision gives limited partners the right to reclaim part of the general partner’s performance fee if later losses reduce aggregate profits.

1. Soft hurdle means once the hurdle is met, carried interest can apply to a larger base through a catch-up arrangement. Hard hurdle means carry applies only to the amount above the hurdle.

Relative Returns and Biases

1. Relative performance needs benchmarks, but alternative benchmarks are dangerous if the peer group is not comparable.
2. Private equity and real estate comparisons are better when investments are from the same vintage year. Vintage year means the year a fund starts its investment life, so funds are compared at similar life-cycle stages.
3. A mature private equity fund harvesting exits should not be lazily compared with a new fund still paying fees and deploying capital.
4. Hedge fund indexes have special bias problems because funds self-report, fail, close, or selectively join databases.
5. Survivorship bias happens when failed funds are excluded from the index, making average reported returns look too good.
6. Backfill bias happens when successful funds join an index later and add their good past returns to the database.
7. Both survivorship bias and backfill bias create upward bias in hedge fund indexes.