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LM02 Alternative Investment Performance and Returns 2025 Level I Notes © IFT. All rights reserved 1 LM02 Alternative Investment Performance and Returns 1. Introduction ........................................................................................................................................................... 2 2. Alternative Investment Performance .......................................................................................................... 2 3. Alternative Investment Returns .................................................................................................................... 6 Summary ...................................................................................................................................................................10 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM02 Alternative Investment Performance and Returns 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction This learning module covers:  Issues in performance appraisal of alternative investments  Calculating fees and returns of alternative investments 2. Alternative Investment Performance Alternative investments differ from traditional asset classes in the following ways:  Longer time horizons  Unique patterns of cash flows  The use of leverage  Illiquid positions  More complex fee structures  Different tax and accounting treatment  Less normally distributed returns Due to these characteristics, it can be difficult to conduct performance appraisal on alternative investments. When evaluating alternative investments, four factors should be considered:  the life cycle phase of the investment  the amount of borrowed funds used to maintain the market position  the valuation of the assets  the fee structure of the fund Investment Life Cycle Life cycle phases of various alternative investments generally fall into three distinct periods, as shown in Exhibit 1 from the curriculum.
LM02 Alternative Investment Performance and Returns 2025 Level I Notes © IFT. All rights reserved 3 Capital commitment: In this phase, managers identify and select appropriate investments with either an immediate or a delayed commitment of capital (known as a capital call). Returns are typically negative during this phase because fees and expenses are incurred immediately prior to capital deployment, and assets may generate little or no income during this period. Capital deployment: In this phase, managers deploy funds to:  construct or make property improvements (in case of real estate or infrastructure fund)  incur expenses in the turnaround of a mature company (in case of private equity)  initiate operations for a startup (in case of a venture capital) Cash outflows typically exceed cash inflows. Management fees further reduce returns. Capital distribution: If the property improvements/turnaround strategy/ or startup phase is successful, the underlying assets will appreciate in price and/or generate income exceeding costs. The fund can realize substantial capital gains from liquidating or exiting its investments. Private Equity and Real Estate Performance Evaluation Private equity and real estate investments often display a J-curve effect – initial decline followed by strong growth over the long term. This is because both private equity and real estate require significant initial cash outlays, and the investments take some time to turn profitable. Therefore, it is inappropriate to use short-term performance measures for private equity and real estate. Instead, the following measures are commonly used. Performance measures for private equity: The IRR calculation is frequently used to evaluate private equity investments. However, IRR has certain limitations as a performance measure for private equity:  It doesn’t take into account unrealized gains (since it only considers cash flows).  It assumes that interim cash flows are reinvested at the same rate as the IRR of the investment (which may or may not actually be earned).  And finally, it needs an assumption of the financing rate to use for outgoing cash flows to compare with the IRR to evaluate whether the return is more than what the required rate would be for the given amount of risk in the investment. To overcome this complexity, the multiple of invested capital (MOIC), or money multiple is frequently used. It simply measures the total value of all distributions and residual asset values relative to an initial total investment. MOIC = (Realized value of investment + Unrealized value of investment)/(Total amount of