Understanding Alternative Investment Assets in Detail

Evaluating and comparing the performance of different alternative investment options can be tricky for investors in India today. The universe of alternatives has expanded vastly beyond the traditional choices of gold and real estate. Asset classes like private equity, hedge funds, commodities, art and collectables are gaining more attention.

But how can investors analyse expected returns vis-à-vis risks across such varied assets? In this chapter, we will explore the concept of performance evaluation and benchmarks.

Performance evaluation involves measuring and comparing returns generated by different investment opportunities after accounting for the risks taken. This enables choosing assets that provide the best returns per unit of risk assumed.

For example, private equity, which is money invested in private companies, often makes more money than investing in a big list of companies called the S&P 500.

By looking at risk-adjusted returns, investors can identify investment opportunities that provide superior returns per unit of risk taken. Essentially, performance evaluation helps select investments where the probability of gains adequately compensates the risks. It enables the construction of an optimal portfolio that maximises returns for the given risk appetite.

Performance evaluation in private markets is more art than science. It involves assessing not just the financial returns but also the strategic growth and market position of investments, which often include private equity, real estate, and venture capital.

• Complex Metrics: Unlike public markets, where performance is often gauged by stock prices and market capitalisation, private market investments require a deeper dive. Here, metrics like Internal Rate of Return (IRR), Distribution to Paid-in Capital (DPI), cash-on-cash returns, and multiples on invested capital come into play.
• Long-Term Horizon: Private market investments typically have a longer-term horizon. This means performance evaluation must consider how investments evolve and mature over time, often spanning several years.
• Wider Range of Strategies: There is considerable diversity in alternative asset strategies, ranging from passive index tracking funds to active hedge funds with dynamic trading strategies across asset classes. Their risk-return profiles can vary significantly.
• Lack of Regulation: Alternatives are relatively less regulated than traditional assets. There are fewer standardised disclosure requirements. Performance evaluation provides transparency.
• High Costs: Management and performance fees for alternatives can be steep, especially in active strategies. Evaluating if higher costs result in superior risk-adjusted returns is essential.

1. Multiple of Invested Capital

   This metric is far-sighted. It does not care about smaller deviations here and there. It only cares about where you end at the close of the day.

   It’s like measuring the total treasure you’ve unearthed compared to your initial digging effort, or in financial terms, the total value returned from an investment relative to the amount initially invested.

   MOIC is calculated by dividing the current value of an investment (including any distributions received) by the original amount invested.

   Let’s imagine two treasure hunts.

   In the first, you find small treasures ($10,000) yearly for 10 years. In the second, you find a huge chest ($200,000) at the end of 10 years. MOIC points to the big chest as the greater treasure, not minding that it took a decade to find.

   MOIC is quite an absolute measure. It’s a simple but effective way to gauge how much value an investment has generated in absolute terms, without factoring in the time taken to achieve those returns.

2. Internal Rate of Return

   IRR measures the annualised rate of return generated by an investment over its lifetime. It equals the discount rate at which the net present value of costs equals the net present value of returns.

   For example, imagine two different investments as follows.

   Investors A and B both invest $100,000 each in a startup of their choice.

   Within a year, Investor A exits with $120,000. The MOIC is 1.2x ($120,000 / $100,000) in this case, but the IRR is high because the return was achieved quickly.

   Investor B, on the other hand, stays invested over five years and then exits with $200,000. The MOIC is 2x ($200,000 / $100,000) in this case. The IRR is lower because the return took longer, despite the higher overall return.

   In other words — IRR prioritises faster returns as opposed to a gradual build-up. It also does not take into account the other qualities or even the conditions of the market.

3. Public Market Equivalent (PME)

   PME analysis is used to calculate the alpha of private equity funds relative to the public markets. This measure is based on a completely different premise. It asks the question: “How would this private equity investment have fared if the same amount of money had been invested in the public market instead?”

   Let’s consider an investment made in a private equity fund and a parallel hypothetical investment in a public market index.

   Imagine you have two investment options. Each requires the same cash investments at the same times, but one is in a private equity fund and the other in a public market index.

   The private equity investment involves specific cash inflows (investments) and outflows (returns) over the fund’s lifetime. The timing and amounts of these cash flows are key. For the public market equivalent investment, we replicate the exact timing and amounts of the cash flows from the private equity investment into a public market index.

   PME analysis compares the final value of the private equity investment with the final value of the hypothetical public market investment. It provides a direct, date-and-cash-flow-matched analysis of returns between the two investment scenarios.

   It is important to note that PME is not about assessing the risks, or the investment journey of the private equity fund or the public market index. Rather, it offers a method to directly compare the returns of the two, assuming identical cash flow patterns. The focus is on the performance outcomes, not on the risk profiles or investment strategies of the respective investments.

In investing, a benchmark is a standard point of reference used to evaluate the performance of a portfolio. Benchmarking allows investors to compare the returns generated by their portfolio to a suitable market index or composite. This helps assess how well the portfolio is doing relative to the overall market.

In 2023, many index or large-cap funds that just follow the market couldn’t do better than the benchmarks they were compared to. This means the funds didn’t earn more money than the average market performance.

A benchmark should represent the investment universe and risk-return profile of the portfolio it is being compared against. For example, a large-cap equity fund would be benchmarked to a major index like the S&P 500 that covers the large-cap space.

Benchmarks are really important in alternative investments because they help investors see how well their money is doing compared to other options. They are like a scorecard.

For example, in the first half of 2023, a huge number of equity funds in France, Italy, and Spain didn’t perform as well as their benchmarks. Specifically, 94% in France, 96% in Italy, and 99% in Spain fell short. This shows that most funds in these countries couldn’t beat the average market performance.

In the context of private equity and venture capital funds, vintage year benchmarks are particularly significant. These are the performance metrics of investment funds categorised by the year they started making investments. This is crucial because funds of the same vintage year are exposed to similar market conditions and economic cycles. Comparing funds based on their vintage year therefore offers a more meaningful performance assessment, as opposed to general market benchmarks that might not reflect the unique nature of these investments.

Vintage year benchmarks serve several roles:

• Performance Comparison: By grouping funds based on their inception year, investors can compare funds against a more relevant and fair benchmark. For instance, a PE fund started in 2015 would be benchmarked against other funds that began in the same year.
• Market Context: These benchmarks help in understanding how specific market conditions in a given year affected investment strategies and returns. They account for economic cycles, making them crucial for evaluating long-term investments like PE and VC.
• Strategic Insights: Investors use vintage year benchmarks to gain insights into the effectiveness of different investment strategies during specific periods. This assists in making informed decisions for future investments.
• Portfolio Construction: For investors building a diversified portfolio, understanding how funds of different vintage years have performed helps in selecting a mix of investments that can balance risk and return over time.

Benchmarks are indispensable yardsticks that bring transparency and perspective to performance evaluation for investment portfolios.

Let’s take a look at how some of these classes compare:

Key aspects:

• Private equity has delivered the highest returns historically but also tends to be highly illiquid and risky. Hedge funds provide moderate returns with lower volatility and drawdowns.
• Commodities and art/collectables provide high returns during bull markets but suffer from deep drawdowns in bear phases. They rank lower on risk-adjusted return metrics.
• Real estate and infrastructure offer steady cash flows but are relatively illiquid investments with moderate returns for the locked-in periods.