Lesson 1 of 10 · All lessons in this module
- Why appraisal is harder: the life cycle and the J-curveVideo lesson
- Measuring returns: IRR versus MOICVideo lesson
- Leverage: magnifying gains and losses
- Valuation: fair value levels and smoothed returns
- Fees, custom terms and redemption provisions
- Hurdle rates, catch-up, waterfalls and clawbackVideo lesson
- High-water marks, investor timing and either/or feesVideo lesson
- Integrated case: hurdle rate and high-water mark in one fee
- Integrated case: three investors, one fund, four years
- Funds of funds, benchmarks and index biases
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Lesson 1 of 10 · 12 min
Why appraisal is harder: the life cycle and the J-curve
Alternative investments are customised, long-lived and lumpy in their cash flows, so a simple period return tells you far less than it does for a listed share or bond.
In short
- Listed stocks and bonds are standardised claims with continuous prices, large peer groups and common indexes, so comparing their performance is easy.
- Alternatives complicate appraisal through the timing of cash flows, borrowed funds, valuation of illiquid positions and complex fees, tax and accounting.
- A typical fund passes through capital commitment, capital deployment and capital distribution.
- Returns are usually negative early on and accelerate later, tracing a J-curve; they flatten as assets are sold and the fund winds down.
- Alternative returns are also less normally distributed, so standard risk and return measures can mislead.
Why listed securities are easy to compare
A listed share or bond is a standardised claim. Every holder of the same share gets the same dividend; every holder of the same bond gets the same coupons and principal. Buying it requires no further capital later.
Prices are quoted almost continuously, there are large peer groups of similar securities and common indexes to benchmark against. Measuring a return over a quarter or a year is a matter of reading two prices and the income in between.
Alternative investments are customised. Two investors in the same fund can have different entry dates, different fee terms and different cash flow histories, so there is no single 'return of the fund' that applies to everyone.
| Feature | Listed equity and debt | Typical alternative investment |
|---|---|---|
| Cash flows | Standard dividends or coupons | Irregular capital calls and distributions |
| Borrowed funds | Usually none inside the security | Often leveraged, magnifying gains and losses |
| Valuation | Quoted market prices | Models and estimates for illiquid positions |
| Fees, tax, accounting | Simple flat fee | Management plus performance fees, custom terms |
| Return distribution | Closer to normal | Less normal: skew, fat tails |
When you appraise an alternative investment, look at four things: where it is in its life cycle, how much borrowed money it uses, how its assets are valued, and how its fees are structured. The rest of this module takes them one at a time.
The three phases of the investment life cycle
Capital commitment. The manager raises commitments and selects investments: a start-up for venture capital, a mature company for private equity, buildings for real estate. Money is drawn from investors through capital calls, immediately or later. Fees and set-up costs start at once while the assets earn little or nothing, so returns in this phase are usually negative.
Capital deployment. The manager puts the money to work: constructing or upgrading property, turning around a company, launching a start-up's operations. Cash going out usually exceeds cash coming in, and management fees keep weighing on returns.
Capital distribution. If the plan works, the assets rise in value or generate income above their costs, and returns accelerate. The fund then exits, for example through an IPO of a venture-backed company or the sale of properties, often realising large capital gains that are paid out to investors.
The J-curve
Plot a fund's cumulative net cash flow (or cumulative return) over its life and you usually get a shape like the letter J: a dip below zero during commitment and deployment, then a steep climb as investments mature and are sold, and finally a flattening as capital is returned and the fund closes.
This J-curve effect is why a fund's early performance figures say little about its final outcome. It is also why comparing a fund in year 2 with a fund in year 8 is misleading: they sit on different parts of the curve.
Because the size and timing of cash flows drive the result, long horizons also make taxes matter. Different tax treatments of income and gains can change after-tax returns materially over a ten-year fund life.
Worked examples
Example 1 Reading a J-curve
A Swedish buyout fund's net cash flows to investors (SEK millions) are −40, −60, −30, +10, +50, +90 and +60 in years 0 to 6. In which year is the cumulative position lowest, and when does it turn positive?
Example 2 Which phase?
A real estate fund has drawn all its commitments, is refurbishing three office buildings and receives only small rents while paying contractors and management fees. Which life cycle phase is it in, and what return pattern should an investor expect?
On the exam
Expect questions on which phase produces positive cash flow, on describing the J-curve, and on which features (not the fee level itself) make alternatives hard to compare with listed securities.
- Saying the fee level is what complicates appraisal. It is the complexity of the fee arrangement that matters.
- Expecting positive cash flow in the deployment phase. Outflows still exceed inflows there; investors are normally paid in the distribution phase.
- Comparing funds at different points on their J-curves as if they were like for like.
Check yourself
Q1In which phase of a private equity fund's life cycle should investors most likely expect positive net cash flow?
Q2Which of the following least likely makes it harder to compare an alternative investment's performance with that of listed equities?
Q3A fund's net cash flows (CHF millions) in years 0 to 4 are −15, −25, −10, +20 and +45. Its cumulative net cash flow is lowest at the end of year:
Q4The J-curve effect is best described as:
Q5Why are management fees especially visible in a fund's early returns?
Answer the 5 questions: +10 XP for each one you get right first time.
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